🤔 This is another post in a set of posts on options trading on the blog. If you are confused on terminology, go back and start with the first post and the series and work your way to this one.

Dark Road with Mountains

My options trading journey started back in September 2020 and I learned a lot in a short amount of time. This post covers some of the lessons I’ve learned along the way.

Edwin Lefèvre says it best as Larry Livingston in Reminiscences of a Stock Operator:

Whenever I have lost money in the stock market I have always considered that I have learned something; that if I have lost money I have gained experience, so that the money really went for a tuition fee.

Make a set of rules and stick to them

This was one I learned early on from Joonie, the leader of the Theta Gang. His podcasts covered this topic frequently and the importance of this step cannot be understated. Everyone needs a strong set of rules when making trades so that emotion can be removed from trades.

Emotion easily sneaks in and clouds your judgement whether your investments are green or red. When emotion takes over full control, you become “tilted” (as Joonie says), and you make poor choices. You can quickly over-leverage yourself and ruin a winning position. You can also throw good money after bad and make your losing positions worse.

Start by building a set of rules that you can follow, or better yet, add to a screener (more on that next). Here is my rule list as of today for selling puts:

  • The underlying stock must be a stock I would enjoy holding for an extended period (potentially weeks or months).

  • The underlying stock must be priced higher than $10.

  • Choose a trade between -.20 to -.30 delta on a monthly expiration date (no weeklies). This is roughly 70-80% chance of profit.

  • Make trades on an underlying that is moving sideways or has a long upward trend above the 50 day exponential moving average (EMA), but avoid any underlying stock with spikes or gaps up that aren’t explained by solid news. (This avoid pump and dumps or other manipulative patterns.)

  • The monthly expiration should be between 21-60 days away from the current date.

  • A trade should have an annualized return over 20%.

  • No earnings reports or other news should be scheduled before expiration. (Earnings are dangerous and unpredictable, even if you somehow get an advanced copy of the filing.)

By following your rules closely, you avoid making trades that you regret. However, market conditions could lead you to bend one of these rules. For example, if the market is fairly steady and the underlying has been moving sideways for a while, I may move closer to -.30 to -.40 delta (about 60-70% chance of profit).

Know exactly when you will exit the trade

This one is separate from the rules list above because it is important all by itself. When you enter any trade in the market, have an exact exit strategy in mind.

For my trades, I always exit when I have reached a 50% profit. If I sell a $90 put on AMD and get $2.50 in premium, I immediately enter an order to buy it back at $1.25. This takes all emotion out of the trade and it ensures that I won’t miss out on profits if I am away from the computer. It’s a great feeling to suddenly get a notification from your broker that you made money when you least expect it. 🤗

Always remember: profit is profit. I may make $1.25 on that trade while someone else makes $2.50, but my capital is freed up earlier for other trades and my profit is secured. I’d take a 50% gain over a loss of any size.

Wait on trade ideas to come to you

Sometimes the best trade is not to trade at all. My trading rules are fairly easy to pack into a scanner and that’s usually how I research my trades. I scan for options on Barchart and I will occasionally use finviz to find new stocks that should be on my radar.

I get an email from Barchart about an hour after the market opens with my list of options that meet my criteria. From there, I decide on which ones to trade and which ones to skip. If there’s something good in the list, I’ll make a trade. Otherwise I’ll wait for the conditions to line up with my investment goals and rules.

Trade outside the crazy market hours

I avoid trading during the first hour the market is open (9:30-10:30AM Eastern) and the last hour (3:00-4:00PM Eastern). The trading volume is really high around these times and it can be difficult to figure out what a stock is doing during those times. Day traders and swing traders are extremely active during this time.

Be patient with limit orders

Always use a limit order when selling options and be patient with them. For example, if the bid/ask spread is $1.00 to $1.10 and you decide to set your limit order to $1.05, be patient. Many people will rush to lower the limit when the trade does not execute immediately, but you should stick with your order.

Selling puts on volatile stocks allows you to collect premium, but volatile stocks have volatile options, too. I usually set my limit orders right in the middle of the bid/ask spread and wait. About 90% of the time, the order executes within a few minutes because the stock price is volatile.

Trade where other people are trading

Be sure to find out where the most active options are being traded in the market. Options volume helps you enter trades quickly at good prices. It also helps you exit when it’s time to take a profit. Stocks with low volume options trading can provide good premiums, but it can be challenging to exit the trade when you’re ready to capture profit or limit your loss.

Use care when you follow unusual options activity reports. It can be exciting to jump in on trades when you see lots of money pouring into puts and calls.

However, many of these big options trades are hedges from larger firms who want to avoid losses or capture extra gains for their clients. There’s also some market manipulations strategies here where people buy tons of calls on a stock in the hopes that market makers will buy lots of shares.

Scrutinize skyrocketing stocks

Sometimes you’ll see a stock that has traded sideways or posted small gains day after day and then it suddenly shoots straight up (often called “mooning”). These look like great targets for selling puts at first, but you should be cautious.

Stocks sometimes do this when big news comes out about a company. For example, if a small semiconductor company makes a deal with Apple to put chips in new laptops, there’s a good chance that the small semiconductor stock will moon wildly. The market does this because the company’s valuation is now in flux. Is this company’s valuation now 50% more? Double? Quadruple? Be careful until the market decides on the new valuation.

You may also see situations where stocks go through the roof and there is no news, no big insider trading, and no significant industry news. This is where you should be extremely cautious. Prices often do this when the stock is being manipulated or when activist investors are at work.

The worst case is that the stock is headed into a “pump and dump” scheme where shares are rapidly being bought in the hopes that other investors will buy it up thinking that some news is about to come out (the “pump”). Once a lot of new investors pile on, the group buying the shares stops and sells all their shares (the “dump”).

The dump side often involves investors called “shorts” who short the stock and cause the price to go down further. This is a dangerous move for shorts if the buyers keep buying as this could lead the price to skyrocket again and force shorts out of their shares.

Avoid trading around earnings

Earnings are some of the wildest times in the market and they’re incredibly hard to predict. I’ve seen companies post excellent earnings reports with glowing numbers, great sales, and excellent predictions. As soon as the earnings come out, the stock falls 20%. 🤯

Keep in mind that valuation is a tricky thing and that many investors won’t agree on a valuation for a particular stock. A great example is that one of the analysts following Tesla raised the price target from $90 to $105. Tesla is trading at over $700 today. Again, valuation is in the eye of the beholder.

I’ve also seen companies post terrible earnings reports and their stock remains flat or goes up. There’s a chance that investors already predicted the bad results and they’re priced in already.

Something that may look good at the moment may turn out awful later. For example, if a company releases earnings after the market close, they may only release a PDF after the market closes that includes their SEC filing data. That data may look fantastic and the stock moons immediately. Later, when the company has their conference call, they announce they’re acquiring another company and they are revising future estimates down by 20%. The stock prices falls through the floor.

Even if you had an advanced copy of a company’s earnings filing, it would still be incredibly difficult for you to make a trade that will make a profit once the market is closed.

Track your trades

Keep yourself honest by tracking your trades. I track mine on thetagang.com and it’s a free way to analyze your trading strategy. You can find other people trading the same stocks and ask them questions. There is also a list of trending stocks that is updated frequently and this can help you build your own watchlist.

You can learn a lot from reading notes from other traders about their trades. I encourage you to leave good notes as well since this tests your conviction on the trade. If you’re not confident enough to explain to other people why you made the trade, then why make it in the first place?

There are a litany of spreadsheets out there for tracking trades as well, but the best one I found is the Options Tracker Spreadsheet from 2 Investing. It pulls stock quotes directly from Google Finance and it calculates helpful metrics, including annual return metrics.

Like water off a duck’s back

When you win, take time to understand what worked in your favor so you can repeat it.

When you lose, take time to understand what went wrong and what concrete things you plan to change.

I was up almost $3,300 at the end of 2020 and I chased a skyrocketing stock, FUBO, much longer than I should have. It mooned without much news and I kept chasing it. That led to a loss of over $5,000 and my end of year finish was negative.

My mistake was that I had so many winning trades back to back that I got “tilted” and violated my rules. Initially, everything looked good, but once it turned after hours, there was nothing I could do. I continued to hold and hoped that the conditions would change, but nothing changed. The loss stopped the bleeding and I would have easily lost $2,000 more if I had not exited when I did.

After this failure, I went back to my list of rules and made them more strict. I’m also working on a script that allows me to maintain a watchlist and let quality trades filter through that match all of my rules. I plan to put the script on GitHub soon once it works. I also shared my failure with other people and told them what I thought I did wrong.

The loss still hurts, but I’m trading again to make up the loss. My goal is still to donate a percentage of my gains to charity, so I keep that goal in mind. The key is to stay in the game.

Disclaimer: Keep in mind that I am not an investment professional and you should make your own decisions around stock research and trades. Investing comes with plenty of risk and I’m the last person who should be giving anyone investment advice. 😜

Photo credit: Artem Kniaz on Unsplash