Options Trading: 5 Basic Rules of Thumb
By: Steve Smith
One of the members of my Options360 service wrote asking whether I had hard rules for managing my options trading. He knows I’m pretty much a stickler for entry points relative to the underlying shares, but when it comes to applying the options strategies, I allow more leeway for flexibility.
That, in fact, is one of the reasons I love options trading. There’s nuance to position selection and management, and it’s as much art as a science, allowing you to find a personal style.
That said, I do have some rules of thumb that have served me well over the years.
- When being a net buyer of premium(purchasing long options, purchasing vertical spreads, etc), I like to choose expirations beyond 50 days out. Once inside 21 days, theta drag really starts to become a problem for any long premium I have and I’ll usually be looking to exit any open long premium trades at this time.
- Conversely, when selling premium or income trades (selling naked options, short vertical spreads, Iron Condors, etc), the sweet spot to enter is when there is no more than 45-55 days until expiration.This gives us a chance to earn nice premium while putting us in position to capitalize from an accelerating theta
- When buying straight long calls or puts, I like to choose out-of-the-money nearest to(+/-) 25 delta strikes. It’s a nice mix of affordability (bang for the buck) and opportunity to profit. When we’re right, the leverage is a nice kick. When we’re wrong, the loss doesn’t hurt so much.
- Conversely, when selling naked puts or calls– which I do not recommend because of the unlimited risk–but some people like to do with strangles or straddles as an aggressive means of premium collection I would suggest starting with 25 delta options to allow some room to wrong without being knocked out of the position.
- When doing calendar spreads, I like to choose the strike where I think prices are likely to stall (support or resistance) — this gives me an opportunity to cover the short option cheaply and hopefully ride the back month long option to better prices later. Of course, if the underlying trades to my strikes before I’ve closed the short option, then I’ll just close the entire spread and book the profit.
When selling iron condors, I often like to chose the 25 delta options for my short strikes and the 5 delta options for my long strikes. This results in an unbalanced Iron Condor where there is often more risk on one side of the trade than the other, but at trade initiation the deltas balance out to neutral, which is where I want to be.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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