Options Trading wiki Page 1 of 5
Options as a trading strategy
How to be a trader by Scott Tafel
By Scott Tafel
There are lots of places you can go on the Internet to find out the basics of options; what we want to do here is move past the basics (i.e. what is a Put, what is a Call, what is a Strike Price, etc.) and discuss how to move forward with a winning options strategy. Options trading strategies can be divided into two categories: 1) Directional, and 2) Theta decay. In a directional play the underlying needs to move more or less in the right direction for you to make money. When putting on a Theta decay trade you care capturing the time decay of the option premium and trying to stay neutral in terms of direction.
There are two ways to setup an option trade: as a credit (option seller) or as a debit (option buyer). Professional traders rarely put on a debit spread unless it is a Butterfly spread. On average most options will expire worthless, which tips the advantage in favor of the seller of options. Additionally, when you speak to people who are successful options traders, there are very few successful traders who have been trading options for more than four years and are option buyers as their main options strategy. As an option buyer you can go through periods of time when you make good money but it should not be your only strategy. Every now and then you get the right setup and you put on a debit spread, but most of the time you should be looking at credit spreads.
  • Boost your profits by being with the right broker Jump to Here
  • Making Money with Position Sizing Jump to Here
  • Debit Strategies Jump to Here
  • Memory - If you don't have enough memory then your trading programs will run too slow. More
  • Power Supply - A strong power supply is the foundation of a strong trading computer. More
  • Graphics Cards / Video - If you want multiple monitors you will need a good graphics card, maybe more than one. More
  • Hard Drives - Solid State hard drives are a must for a modern trading computer. More
  • Internet Speed - Your Internet connection is important for getting your orders fills quickly. More
  • Warranty - You will depend on your warranty as much as you will depend on your trading computer. More
Boost Your Profits by Being with the Right Broker
The account size you have will determine what options strategies will work best for you and how profitable you will be. An important rule that will affect you if your account is less than $30,000 is the Pattern Day Trader rule by FINRA. This rule is often enforded at different points by brokers that the rule requires. The rule states that 1) If you are trading in a margin account, and 2) You buy and sell a particular security in the same trading day four or more times in any five consecutive days; then you are a Pattern Day Trader and must maintain a balance of more then $25,000 or your account will be frozen from opening new positions for 90 days.
options trading pattern day trader warning TOS
options trading pattern day trader warning TOS
Most brokers go beyond the minimum requirements. In TradeStation you are required to have at least $30,000 but it is not applied to cash accounts. With TDAmeritrade they will prevent you from doing a day trade once you reach three day trades in five days threshold (see screen shots at left).
What constitutes a day trade is open to some interpretation by your broker. If you buy the same option in three trades on the same day, and sell them all in one trade (which could be simply making an adjustment that takes multiple trades to accomplish), that can be considered 1 day trade or 3 day trades. If you buy in one trade and sell the position in 3 trades: that is considered 1 day trade. Closing a position to meet a margin call still counts towards the day trading limits if it was also purchased in the same day. In a cash account, if you close an stock position then you need to wait three days before re-using those funds or you will be guild of a free riding violation. In the case of closing an option trade then the buying power reduction done as part of the trade can be re-used the same day but the value of the options that were closed out cannot be used until the next day. So if you sold an option for $1 on a $5 spread and then bought it back for $.50 then you cannot re-use that $1 until tomorrow but the other $4 of the spread can be used the same day with many brokers.
If you have an account over $100,000 and you trade strangle/straddle options frequently then you are might be better off using a broker that offers Portfolio Margin (Interactive Brokers & TDAmeritrade). Interactive Brokers offers Portfolio Margin with the almost no experience restrictions. TDAmeritrade will have significant experience restrictions in order to qualify for Portfolio Margin. With Portfolio Margin you can get up to six times more buying power than with regular account margin when you are trading options. Portfolio Margin will have a much smaller benifit (or no benifit) with stock trades.
options trading How much you pay your broker in trading commissions is a big deal. TradeStation is a low cost broker with a great trading platform. With TradeStation a typical active trader will pay $4.99 - $6.99 for a stock or option trade but if you plan on making heavy use of margin (specially Portfolio Margin) then Interactive Brokers has the lowest margin rates.
Your option trading platform can have special features that improve your trading performance (if you use them). The ThinkOrSwim (TOS) by TDAmeritrade is used by many traders and offers special features such as Porbability of Profit and Implied Volatility Rank (more on this later). The Dough platform for TDAmeritade (see dough.com) is free and gives you the best visual layout. Dough is best used in conjunction with TOS also includes an overly of the standard deviation for probability of profit (POP). With POP overly on Dough you can place a trade and know the exact chance of making money. TradeStations Option Station Pro is an excellent platform for options traders and includes probability ITM/OTM (same as POP but with different words). If you put on a lot of option positions then TOS will sort them out better than any platform so you can see what is going on.
Making Money with Position Sizing
At the end of the year you can have a majority of winners but still lose money. Making money is a combination of winning percentage, average winner size vs. average loser size, how much size you put on, and broker fees. You could have a 60% winning average and still lose money if you lose $3 on your average loser and make $2 on your average winner. How much you pay your broker is important because you must pay your broker on losing trades as well as winning trades so winners become smaller and losers become bigger.
If you bet too big on your trades then you will be unprofitable because your winners will only be a way of getting back to even. Ralph Vance did an experiment with 40 PhD's in which they would gamble 100 times in a game where they would be guaranteed to win 60% of the time. They started out with $1,000. If they had bet exactly $10 on each round they would have each had $1,200 left at the end of the test.
If they had bet the mathematically optimal amount of 20% then they would have had $7,490. However, only two had more than $1,000 at the end of the test. These were smart people who thought that they could do it by using their instincts rather than by calculating the correct answer. If you lose 20% of your account then you need to earn 25% profits to get your account back to where you were. If you lose 25% then you need 33% in profits, if you lose 40% then you need 67% in profits, and if you lose 50% then you need 100% in profits to get back to even money. You should only risk a small percentage of your portfolio, less than 10%, on any one trade and as your account gets bigger you should risk less and less on any one trade.

Scott Tafel is the founder and principle partner in Falcon Trading Systems: computers for traders. He has been a trader since 1999. Mr. Tafel spent 27 years working in the Nuclear power industry, principally as a Nuclear Reactor Operator.
option trading