Managing Your Trading Options Costs - dummies

By Joe Duarte

There are a variety of costs to consider with your trading — some are higher when you first start and many continue throughout your career. You need to think of trading as a business and manage these expenses so you can minimize them and their effect on how much money you actually earn as a trader as your business matures.

The expense categories included in the following list will all continue throughout your trading career, but some will begin higher than others:

  • Education: Education expenses include materials, courses, and learning curve costs for new markets and strategies. These costs will decrease as time progresses, but will remain ongoing as you stay current with market conditions (books, periodicals) and continue to develop new strategies.

    One of the largest education costs is your learning curve. This tends to decline as you figure out how to do the following:

    • Trade under best conditions for the strategy.

    • Use options with the appropriate liquidity.

    • Develop paper-trading skills.

    • Allocate the appropriate amount to the trade.

    • Effectively enter orders for the best exit.

    • Take profits.

  • Analysis costs: As your skills progress and your trading generates ­regular profits, you may add analytical tools to your business costs. Talking to fellow traders that use such tools and finding out which ones you may be able to take for a spin using free trials are good ways to start.

    Such costs represent one of the few that may increase over time. Be sure to only subscribe to a limited number of services and get to know them well so you can make the most out of them.

  • Trading costs: You have to not only account for commission but also for slippage. Slippage is the cost associated with the market spread — the difference between the bid and the ask. A good exercise is to calculate commission and slippage percentages for different size option positions (for example, 1, 5, 10 contracts) established at different price points ($1, $5, $10).

    Taxes are another consideration, so you need to identify what types of trading will be completed in your different account types. If you do the limited options trading allowed in retirement accounts, you will defer those taxes. Otherwise, you’ll pay taxes on your profits in all non-retirement accounts. You can get the full information on what type of options trading is allowed in retirement accounts from the Internal Revenue Service (IRS).

    In addition, when establishing certain option positions when you already hold a position in the underlying, you may trigger a tax event. Be sure to contact your account about option-trading tax considerations. The bottom line for these cumulative costs is that that in the long term, they must outpace a buy-and-hold approach.

    If you borrow from your broker via trading on margin, you need to add monthly margin interest charges to your trading costs as well. Short option positions have margin requirements that can get complicated. The main consideration for this margin is whether the option is covered or naked. If you decide to move forward with strategies requiring margin, be sure to contact your broker so you fully understand all of the calculations and account requirements. Then add these costs to your expenses.

Losses are another trading cost that should be considered part of doing ­business. They will likely be higher at first, but reduced with time and ­experience. Following these trading plan guidelines should help keep these initial costs to a minimum:

  • Determining the trading allocations: As part of an overall trading plan, you should identify both your total trading assets and your maximum allocations for different assets and strategies. Stock and ETF trading will require larger allocations than option positions. You may even want to break this down further to include a maximum allocation amount for new strategies based on paper-trading results.

  • Calculating trade size: You must also determine guidelines for ­maximum position size prior to entering any trade. Once these are set, identifying the maximum number of contracts you can allocate to a ­position is pretty straightforward. Divide the option price by an allocation amount below your maximum and you’re all set. Don’t anticipate using the max allocation.

  • Identifying maximum acceptable loss on trades: Your maximum acceptable loss can be defined as a dollar value or a percentage. You may prefer the latter because a fixed dollar amount can be significant with smaller trades or if your trading assets decrease. Periodically perform an analysis on your trade results to determine if your losses remain at reasonable and sustainable levels. The bottom line should be how much money is left in your account and whether it makes sense to continue your current approach.

  • Focusing on entry and exit rules: Option entries are often driven by trending and volatility conditions but may also be time oriented with positions created prior to specific scheduled event. Option exits can also be time driven (post-event or pre-expiration) or may be triggered by movement in the underlying security. Regardless, these methods must be focused on supporting your risk management and maximum allowable loss.

Exiting with technical indicators typically does not provide you with a price for use with risk calculations. A maximum loss price should also be identified.