by Ken Trester 08/11/08
Price is the key to success in the options market. When you pay too much for an option, the odds get stacked against you.
Undervalued and low-priced options give you two advantages. First, you are risking less money when you buy a cheap option. It is much easier on the pocketbook to lose $50 than $500 if the option expires worthless. Second, if the stock crosses the strike price (putting it "in-the-money") before your option expires, you not only win your bet but your percentage gains will be more than had you bought a more expensive option.
Finding underpriced options is simple in theory but in the real world it takes an enormous amount of work. We have developed a computer pricing model that does this better than anyone else. This model is to put to work every week in our Maximum Options and Fast Options Profits trading services.
Just as important as selecting the right option to buy and paying the right price is knowing when and how to take profits. Most option buyers lose not because they take the wrong positions, but because they fail to take profits properly.
With options, your first objective is to protect profits, and your second objective is to hit home runs. Most important, when your option begins to profit you must be ready to act.
The best way to do this is to know exactly what you will do with a position when the option hits a specific price. Deciding this in advance, and sticking to your decision when the time comes, removes a lot of emotion from your decision making.
When you buy an option, you should decide in advance what your target price for the option will be. If the option hits its target price, sell half your position (for example, if you bought four contracts, sell two of them). This takes most of your original money off the table. Capital preservation is paramount when you speculate with options.
Then, let the rest of your position ride for possible future gains, using a 5% trailing stop on the underlying stock. A trailing stop can be a "mental" stop, though more and more brokerages are allowing this to be done automatically. The trailing stop adjusts when the stock moves in your direction, and stays the same when the stock moves against you.
For example, if a call option you own hits its target price, sell half of your position. Then if the stock keeps rising, hold the option and adjust the trailing stop higher so that it is never more than 5% under the current stock price. But if the stock falls, do not adjust the trailing stop.
The process is reversed for a put option. If the stock continues to fall after the option hits its target price, keep lowering the trailing stop. But if the stock rises, do not adjust the trailing stop.
Another key for taking profits -- if your option is in-the-money and enters its last week before expiration, close the entire position and take profits. Don't wait for it to expire.
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