3 First Steps When Trading Options

12/03/2012 10:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Transitioning from an investor mindset to an options mindset can be intimidating, so here are the first few steps you need to take to begin the shift, says Dan Passarelli.

The three things you need to get started in options. We’re here with Dan Passarelli, who is going to tell us what those three things are.

Well, you know there are a couple of obvious things to start with. I mean for one, you need to be somewhat capitalized...not that much. I encourage traders to start out with about $5,000—no more. I don’t care if you have $10 million in the bank; start with $5,000.

Then, of course, you need a means to actually make those trades. You need a broker, and there are some really great online brokers out these days that are really options-friendly, provide you with a fantastic suite of tools, really everything you need to get started and trade for a long, long time.

Do you have any that you could recommend? I mean, there’s such a slew of them of out there, and I know some folks might be with a big broker and might want to try this. Some investors might want to get into options, but are there better focused options trading firms or are they all the same?

No, they’re definitely not all the same. I always encourage traders who are looking to get into options to give those brokers a call, or better yet research them online, because it’s more common these days for traders to make trades online in a self-directed trading account.

So do a little bit of research, see if they offer options, find what tools are available, and of course look at their commissions as well. There are plenty of good guys out there.

Because the options, that’s the other thing. I think commissions when you’re trading, it’s a little different than if you’re buying income stocks. I mean the commissions, you’re on short-term contracts for the most part, so you’re going to be in and out fairly regularly.

Yeah, the typical investor might make a handful of trades a year perhaps, but a typical trader is going to make several trades a month. That brings me to the third thing that investors and traders who are looking to get into options must also get under their belt, and that is a little bit of education.

Options are a little bit more complex than stocks. I mean, stocks are what I call linear vehicles. They go up or down and you make or lose money. With options, you have that directional component, you have a time component, and you have a volatility component. So it’s really, really important for traders to get really well versed in the product before they jump in.

Sure. Within that context, some of the things that are involved with options like volatility...can you describe a little bit about volatility and how that affects the prices of options?

Yeah, the volatility is kind of the tricky one for a lot of individuals to really grasp at first. You kind of have to think in a way that you’re buying and not trading to think for all of people anyway.

We all kind of know what the volatility means in the typical context, but in the options world it kind of takes on a different meaning. What it really comes to mean is the relative cheapness or expensiveness of options. It’s a concept called implied volatility specifically.

When implied volatility is high, options are expensive; when implied volatility is low, options are cheap. That implied volatility changes all the time. So this is one of the factors that when you trade options you’re either making or losing money based upon. So it’s really important for everyone to get at least somewhat of an understanding of implied volatility before thinking about trading options.

Yeah, and I think that it’s not as complicated as people make it, but there are important things to know about it at the same time. It’s not as easy as just going out and buying a stock. You certainly in options don’t want to be leveraged on a naked put or a naked call either. So the education component I think is absolutely essential.

Right.

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