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How to buy an option correctly

OTM call options are appealing to new options traders because they are cheap. It seems like a good place to start: Buy a cheap call option and see if you can pick a winner. But if you limit yourself to only this strategy, you may lose money consistently. Watch this video to learn more about buying OTM call options.

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This approach is known as a covered call strategy. The risk, however, is in owning the stock — and that risk can be substantial. Although selling the call option does not produce capital risk, it does limit your upside, therefore creating opportunity risk. You risk having to sell the stock upon assignment if the market rises and your call is exercised. Want to develop your own option trading approach?

how to buy an option correctly

Check out our free section for beginners, experienced, and experts. Often, they are drawn to buying short-term calls.

how to buy an option correctly

Before you answer the speculative-or-conservative question about long calls, consider the theoretical case of Peter and Linda presented in the video below. Watch this video to learn more about leverage. How to Trade Smarter Master leverage. General rule for beginning option traders: if you usually trade share lots then stick with one option to start.

If you normally trade share lots — them maybe 3 contracts. This is a good test amount to start with. You should have an exit plan, period. Even when things are going your way.

Choose an upside exit point, a downside exit point, and your timeframes for each exit well in advanced.

Option buyers are charged an amount called a "premium" by the sellers for such a right.

What if you get out too early and leave some upside on the table? Watch this video to learn how to define an exit plan. How to Trade Smarter Define your exit plan.

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  • Also if you are buying a Call Option you are limited in losing the option premium which in most cases would be much less that what you could lose if you bought the shares directly.
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Whether you are buying or selling options, an exit plan is a must. It helps you establish more successful patterns of trading. It also keeps your worries more in check. Determine an upside exit plan and the worst-case scenario you are willing to tolerate on the downside.

If you reach your upside goals, clear your position and take your profits. If you reach your downside stop-loss, once again you should clear your position. The temptation to violate this advice will probably be strong from time to time.

You must make your plan and then stick with it.

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Far too many traders set up a plan and then, as soon as the trade is placed, toss the plan to follow their emotions. All seasoned options traders have been there. It can be tempting to buy more and lower the net cost basis on the trade. Be wary, though: What makes sense for stocks might not fly in the options world.

The distinction between American and European options has nothing to do with geography, only with early exercise.

Watch this video to learn more option strategies. How to Trade Smarter Be open to learning new option trading strategies. Time decay, whether how to buy an option correctly or bad for the position, always needs to be factored into your plans.

Close the trade, cut your losses, or find a different opportunity that makes sense now. Options offer great possibilities for leverage on relatively low capital, but they can blow up just as quickly as any position if you dig yourself deeper. Take a small loss when it offers you a chance of avoiding a catastrophe later. A liquid market is one with ready, active buyers and sellers always.

how to buy an option correctly

Stock markets are more liquid than option markets for a simple reason. Stock traders are trading just one stock while option traders may binars and options dozens of option contracts to choose from.

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More choices, by definition, means the options market will probably not be as liquid as the stock market. A large stock like IBM is usually not a liquidity problem for stock or options traders. The problem creeps in with smaller stocks. Take SuperGreenTechnologies, an imaginary environmentally friendly energy company with some promise, might only have a stock that trades once a week by appointment only.

If the stock is this illiquid, the options on SuperGreenTechnologies will likely be even more inactive.

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This will usually cause the spread between the bid and ask price for the options to get artificially wide. Watch this video to learn more about trading illiquid options.

how to buy an option correctly

How to Trader Smarter Trading illiquid options drives up the cost of doing business, and option trading costs are already higher, on a percentage basis, than stocks. If you are trading options, make sure the open interest is at least equal to 40 times the number of contacts you want to trade. For example, to trade a lot your acceptable liquidity should be 10 x 40, or an open interest of at least contracts. Open interest represents the number of outstanding option contracts of a strike price and expiration date that have been bought or sold to open a position.

Any opening transactions increase open interest, while closing transactions decrease it. Open interest is calculated at the end of each business day. Trade liquid options and save yourself added cost and stress.

How to Trade Options in 4 Steps

There are plenty of liquid how to buy an option correctly out there. Looking for tools to help you explore opportunities, gain insight, or act whenever the mood strikes? Check out the intelligent tools on our trading platform.

There are a million reasons why. Watch this video to learn more about buying back short options. How to Trade Smarter Know when to buy back your short options.

If your short option gets way OTM and you can buy it back to take the risk off the table profitably, do it. One of these days, a short option will bite you back because you waited too long.

How to Avoid the Top 10 Mistakes in Option Trading

This is especially true if the dividend is expected to be large. To collect, the option trader must exercise the option and buy the underlying stock. Watch this video to learn how to prepare for upcoming events. How to Trade Smarter Be sure to factor upcoming events. For example, you must know the ex-dividend date.

See Mistake 8 below for more information on spreads. Sound familiar? Most experienced options traders have been burned by this scenario, too, and learned the hard way.

how to buy an option correctly

Watch this video to learn more about legging into spreads. Trade a spread as a single trade.

Matt specializes in writing about bank stocks, REITs, and personal finance, but he loves any investment at the right price. Follow him on Twitter to keep up with his latest work! Follow TMFMathGuy Options can be a useful investing tool when used correctly, but they can become your worst nightmare if you don't fully understand what you're getting into.

For example, you might buy a call and then try to time the sale of another call, hoping to squeeze a little higher price out of the second leg. You could be stuck with a long call and no strategy to act upon.

Always, always treat a spread as a single trade. You want to get into the trade before the market starts going down. Lots of new options traders never think about assignment as a possibility until it happens to them.