Try Different Trading Strategies before Deploying Them - dummies

Try Different Trading Strategies before Deploying Them

By Joe Duarte

Trading options are different from stocks both in terms of what they represent — leverage, rights, and obligations instead of partial ownership of a company — and how they’re created, by demand. These important distinctions result in the need for additional trading and decision‐making beyond the basic buy or sell considerations.

Part of the learning process, as you transition from direct stock trading to options trading, is developing a new and complementary way of thinking. That includes not just evaluating the price of a stock or an index, but also how the price of the underlying asset along with other factors, such as supply and demand for the option and overall market conditions involved in options prices all come together.

Your final decision, as the trade develops, may be to exercise your rights under the contract or simply exit the position in the market. Fortunately, market prices will help you with those decisions.

If you haven’t traded options in the past, your best approach is to try out some trading strategies on paper and see how things work out. Your goal here is simple: You want to get to the point where you think of your option trades based not just on the option but on the underlying security.

Before you invest real money, you should be able to do the following:

  • Gain a comfortable feel for the activity and characteristics of underlying stocks or indexes on which you are looking to trade options and understand their relationship both to the market and to the options related to them.

  • To be able to mix and match sound strategies to particular market situations while keeping the preceding principles in mind.

Are these extra complications worth it? For many people, the answer is yes — especially when you consider the combined risk reduction and profit potential those options trading offers. And even though making the transition may sound difficult, the actual differences in stock and option mechanics are pretty straightforward and manageable.

At the end of the day, the big advantage to options is the way they provide you with leverage while giving you a mechanism to control the rights to the stock rather than the stock itself.

An important aspect of this mental reshaping exercise involves paying special attention to how the real market action affects the value of options over time. Once you get this part of the puzzle locked in, the rest will fall into place more easily, and your paper trading will be more satisfying.

Along with paper trading, you can also backtest options trading. And don’t worry about how long this learning process may take. Any time spent on decreasing your risk of big losses in the future is well spent.

Widely available options trading and technical analysis programs let you backtest your strategies. Some brokerage houses offer sophisticated analytical packages to their active traders for low prices or for free. Backtesting means that you review how a set of strategies has worked in the past.

Paper trading and backtesting an options‐based trading approach may take a little more time than a stock approach. The advantage is that it could save you a lot of money. Consider paper trading as part of your trading plan.

And even though it may slow down your pace, and possibly delay your getting started in real‐time trading, this type of studious approach will let you address different option trading nuances in advance, and will get you in the habit of being a disciplined trader.