5 Ways to Win with Aggressive Trades
Many traders are tempted into trying their hand at options by the possibility of scoring outsized profits of 100%, 200%, or more. It's true that the ability to reap these big, "home run"-type winners is a major advantage of trading a leveraged vehicle like options. However, beginners should be aware that there's an art and a science to targeting these aggressive profits. Below, we'll reveal our top tips for scoring big with options.
Focus on short-term options. Time decay is the option buyer's enemy. Basically, for every day the trade is open, you're guaranteed to lose time value -- and you need favorable price action in the underlying stock to offset that loss. You can help to stack the odds in your favor by using the shortest-term options available to place your most aggressive option trades. If you're expecting a huge rally next week, buy front-month contracts. If you're banking on a major sell-off tomorrow, weeklies (if they're available) might be the smartest choice.
In other words, you want to match the time frame of your option trade as tightly as possible with the projected price change in the underlying shares. Don't buy any more time premium than you need for the expected move to play out. This not only minimizes the negative impact of time decay, but it also reduces your overall risk on the trade.
Don't invest in intrinsic value. In the same vein, there's not much benefit to buying deep in-the-money options for your aggressive play. These contracts carry higher premiums than at-the-money and out-of-the-money contracts, since they have a comparatively greater probability of expiring with some value.
On one hand, if you're looking to play a longer-term trend in a relatively conservative manner, deep in-the-money calls and puts can be very appealing. But on the other hand, if you're expecting a drastic pop or drop in the stock, why not take advantage of the greater leverage afforded by at-the-money options? Because you'll pay a lower premium to buy the contracts, you stand to reap bigger rewards, on a percentage basis, when the stock makes a significant move in your favor.
Stay open to both bullish and bearish setups. When you hear about big, triple-digit option profits, you might naturally assume we're talking about a stock that's screaming up the charts. But one major advantage to trading options is the ability to adapt your strategy to any type of market environment.
Of course, you can certainly lock in some serious bullish winners by buying calls. That's because your profit potential on a long call position is theoretically unlimited, while your potential risk is strictly capped at the amount you paid to buy the option.
Don't forget, though, that you can also reap leveraged profits with options even when the market is in sell-off mode. In fact, during corrections or bear markets, locking in big winners on a few well-placed put trades can help to offset losses on your long stock holdings. And, unlike a traditional short sale, your risk on a long put position is limited to the initial premium paid.
Keep holding periods brief. When you're looking to reel in a big winner, it pays to be nimble. If the trade isn't playing out as you expected, it's often best to cut your losses and exit the position before you take a 100% loss. After all -- if you're banking on a quick and dramatic price change via short-term options, the stock doesn't have a whole lot of time to recover from an adverse move. By acting quickly to close out an underperforming position, you can preserve some remaining capital and move on to other trading opportunities.
Remember the F.A.R. principle. We often discuss the F.A.R. principle when we talk about option buying. In the best-case scenario, your underlying stock will make a Fast, Aggressive move in the Right direction. This type of price action allows you to not only recoup your entry cost and any time-decay losses, but also collect healthy profits on the position. But how do you find stocks that are solid F.A.R. candidates? We typically use a mix of technical and sentiment indicators to determine if a big, volatile move is in the cards.
From a technical perspective, it's encouraging to see stocks pulling pack to previous support levels -- which could include moving averages, former highs, or round numbers, to name just a few examples. Additionally, some technical indicators can specifically signal when a volatility surge is to be expected (such as compressed Bollinger Bands or the symmetrical triangle pattern).
In terms of the sentiment backdrop, high short interest is a great indicator to look for. When there are a lot of bears betting against an uptrending stock, a short-squeeze rally can provide the fuel for a fast-paced continuation of the rally.
Defending Your Bottom Line While You Swing for the Fences
In the world of trading, you might assume that "aggressive" is synonymous with "high risk," but that doesn't need to be the case. Though you're targeting blowout gains with short-term options, you can still make use of some basic money-management principles to manage your investing capital cautiously.
For starters, of course, never invest what you can't afford to lose. You should risk only funds from a dedicated trading account. When you speculate with capital that you need to meet other financial obligations, you've ratcheted up the odds that you'll make irrational trading decisions based on fear or panic.
Additionally, you should never risk all of your trading capital at one time. Diversity is the key to long-term investing success, so you should have a healthy mix of stocks, bonds, and cash in your portfolio. Options should make up only a portion of this mix -- though put trades add their own dimension of diversity, since they can provide some bearish exposure to complement your long stock positions.
When trading options, use maximum entry prices to determine how much you're willing to pay to enter a trade. The initial premium paid to buy an option plays a huge role in determining your ultimate profit (or loss), so consider using limit orders with your broker to ensure you're adhering to these thresholds.
And don't get greedy -- consider taking partial profits when a trade moves strongly in your favor. By closing out half of your open contracts when the position is at a 100% gain, you've guaranteed that you will, at the very least, break even on the trade. And if the price action continues in your expected direction, you can still profit via your remaining open contracts.
By remembering these simple rules of the road, you can get aggressive with your profit targets even as you remain conservative with your trading capital.
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