10 OPTIONS TRADING RULES AND FUNDAMENTALS
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10 Options Trading Rules/Fundamentals:

A set of trading fundamentals must be followed to successfully run an options-based portfolio. Specifically, position sizing, sector diversity, maximizing the number of trade occurrences, levering IV Rank and risk-defined strategies are some notable areas that traders need to heed for long-term successful options trading not only in small accounts but in accounts of all sizes. 

In order to effectively and successfully run an options-based portfolio over the long-term, the following option trading fundamentals must be exercised in each and every trade. Violating any of these fundamentals will jeopardize this strategy and possibly negate the effectiveness of this approach on a whole. Below are 10 option trading rules for small accounts and accounts of all sizes but specifically small accounts as it pertains to risk-defined strategies when capital is limited.

  1. Spread out expiration dates to avoid expiration density 

    • Spreading options exposure over the course of each month reduces options-specific risk at any given expiration date. Stocks tend to auto-correlate when markets experience dramatic moves and may jeopardized certain option trades that are in play at the time of these sharp market moves. To mitigate this risk, option expiration dates should spread out various expiration dates.   ​

  2. Set the probability of success (options delta) in your favor (70%, 85%, etc.) to ensure a statistical edge

    • Delta is a proxy for probability of success at expiration of an option contract. Provided enough trades throughout various market conditions at a specific delta, the probabilities will play out to align with the delta. For instance, targeting a delta of 0.15 (85% probability of success), given enough trades over time, a win percentage of ~85% will be obtained.     ​

  3. Manage winning trades by closing the trade and realizing profits early in the option lifecycle

    • Proactively managing winning trades is essential to maintain a high win rate and avoid any potential of the trade moving against you in the latter stage of the expiration cycle. If the premium capture is greater than 50% of max profit, closing out the trade and realizing profits is highly recommended as opposed to allowing the option to expire worthless. This closure will realize profits early and free-up the capital for subsequent trades.   ​

  4. Sell options in high IV Rank environments to extract rich premiums

    • Selling options when IV Rank is high provides an edge for option sellers. Since implied volatility is historically overestimated, when IV Rank is high, this provides rich option premium income. When the underlying security fails to be as volatile as predicted, the implied volatility will fall along with the value of the option. When implied volatility reverts to its mean in conjunction with time decay, the option can be closed out for a realized gain.   ​

  5. Sell options on tickers that are liquid in the options market

    • Options must be liquid so option traders can easily and readily buy and sell contracts. Liquidity is essential for tight bid/ask spreads so accurate options pricing can be obtained.   ​

  6. Maximize the number of trades to allow the expected probabilities to play out

    • Given enough trade occurrences over various market conditions at any given option delta, the expected probabilities will reach their predicted outcomes.​ Using a coin toss analogy, flipping a coin 10 times, 100 times or a 1,000 times will result in different outcomes however the more attempts, the closer the 50:50 expected outcome will be achieved.  

  7. Appropriate position sizing / portfolio allocation to manage risk exposure

    • For any well balanced portfolio, no more than 20%-30% of the portfolio should be exposed to options. Any given trade should not constitute more than 1%-3% of the portfolio in order to appropriately manage risk. The number of contracts should be scaled to ensure risk is well managed and not opening up the portfolio for significant drawdowns. ​

  8. Sell options across tickers with ample sector diversity

    • Sector diversity is essential in order to manage risk as certain sectors or industries can auto-correlate and move in the same direction. In order to mitigate several option trades potentially being jeopardized, options need to spread over dissimilar sectors (e.g. AMZN, BA, DIS, FDX, GS, HD, IWM, NKE, SBUX and V)  ​

  9. Keeping an adequate amount of cash on hand (~25% - 40%)

    • Keeping a large amount of cash on-hand is necessary as a mitigation factor and to allow opportunistic purchases of long equity to balance out the portfolio. An options-based portfolio is a holistic approach and long equity positions is an essential anchor.  ​

  10. Risk-defined trades (put spreads, call spreads and iron condors)  

    • All trades need to be risk-defined in order to limit overall risk and leverage a minimal amount of capital.​ Undefined risk trades are capital intensive with unlimited risk.  

 

In addition to the 10 rules outlined above, other general guidelines that are recommended are as follows:

  • Avoid earnings related events 

  • Avoid concurrent option trades on the same underlying ticker (if concurrent trades are placed, ensure adequate time between expiration dates and use different strikes)

  • Avoid strike widths wider than ~$5 (rolling trades becomes more feasible and will allow better opportunities for closing trades)

  • Leverage technical analysis to assist in trade selection such as RSI and Bollinger bands (this can help identify the ideal trade type to select such as iron condors, put spreads and call spreads)

  • Identify companies in the same space that report earnings that may impact your pending option trade (i.e. FDX and UPS / MA and V / FB and TWTR / PYPL and SQ / GS and JPM, etc.)

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Noah Kiedrowski 
Founder and Managing Member

Stock Options Dad LLC

A Registered Investment Adviser (RIA) firm

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