5 Rules for the Low-Budget Options Trader
You don’t need hundreds of thousands of dollars to get started investing in the options market. We’ve created a guide to help low-budget options traders learn how to investigate the market and trade effectively with a smaller initial investment.
What is Options Trading?
An option — sometimes referred to as a “stock option” or “equity option” — is a contract that gives the holder the right to buy or sell an underlying security at a specific price at a specific date. You can purchase options contracts for some of the most popular financial assets, including shares of stocks or exchange-traded funds (ETFs).
One of the most important things to remember about call options trading is that options give you the right but not the obligation to execute them. When you purchase a call option, you pay a price upfront called the premium. The premium gives you the right to execute an option at a pre-defined “strike price” in the future. For example, if shares of Apple stock are trading at $125 and you believe that the price of the stock will rise, you might buy a call option that gives you the right to buy Apple stock at $125 3 months in the future.
If the price of Apple stock falls before the strike date, you may allow your option to expire “out of the money.” However, if the price of Apple stock rises above a certain threshold, the price of the option will rise. You can then choose to execute the option or sell the options contract to another investor. Though there are multiple types of options, these are the basics of how options trading works.
Learning How to Trade Options
Options allow you to invest in the stock market with less upfront financial cost when compared to buying and selling shares of stock. This is because you’ll only need to pay the premium when you first begin options trading instead of the full cost of the stocks you’re interested in. This can provide a great opportunity for new investors on a limited budget. However, it’s never a good idea to jump straight into the market without experience.
If you’d like to learn how to trade options, you can start by investing in an options trading course. Options trading courses are easy to find — and you can learn from the comfort of your home. Some of the characteristics you’ll want to search for in an options trading course may include:
- Self-paced. You may want to review lessons and simulations multiple times before you enter the market. Choose a course that allows you to learn at your own pace.
- Includes market simulations. The best way to learn an options strategy is by testing it out yourself. Choose a course that includes a paper trading account, which will allow you to test out what you’ve learned and solidify strategies in a dynamic environment.
- Affordable and accessible. It’s possible to find options trading courses at a wide range of price points. Stick with more affordable options to learn the basics — you can always upgrade to more advanced, pricier courses as you hone your trading strategy.
Best Practices for Low-Budget Options Trading
When you’re getting started learning about options trading, there are a few rules that you’ll want to follow — especially if you’re working with limited capital. Read on to learn 5 rules to help you start developing your trading strategy.
Rule #1: Set your target price before you begin trading
One of the worst things that you can do is head into the options market without first creating a plan of action. While it might seem like a good idea to hold onto your contract for as long as possible (especially if you’re in the money), know that the price of an asset can change drastically if the stock decreases in value. Options have a set time frame when they’re useful, which means that, over time, a contract becomes inherently less valuable.
Calculate your break even price shortly after buying your contract and set a target price that you aim to sell at. You might even want to use a limit sell order that will automatically execute the contract if the target price is reached.
Rule #2: Know the stocks that you’re buying contracts for
Many new investors believe that the best way to invest is to buy shares of stock of companies that they believe in. While this can be a fantastic long-term strategy, major company names usually have high premiums on options, which can make them inaccessible to low-budget traders. However, this doesn’t mean that you should randomly choose investments that look like they’re gaining value.
Be sure to do plenty of due diligence on both fundamentals and previous market movements before you invest in any company. Read expert opinions on which way the stock may move and invest according to companies that stock experts anticipate will increase in value. Failing to do your due diligence results in gambling — not investing.
Rule #3: Take advantage of stop-loss orders
One of the major risks of options trading is that, if your option expires out of the money, you’ll lose 100% of the value that you paid in your premium. However, there is a way to prevent excessive losses while trading.
A stop-loss order is a type of order that automatically sells off your held options if the price of an option falls below a threshold that you set when you place the order. It’s best to use a stop-loss order when you’re unsure about how a stock will move in price can help you prevent excessive losses.
Rule #4: Avoid stocks you see in the news
One common mistake that new investors make is jumping into stock options that they see in the news. Oftentimes, highly publicized stocks see a sudden jump in price, which usually comes along with a sharp increase in options prices.
Unfortunately, by the time news makes it to market, an option may already be highly inflated. If you’re a new options trader working on a small amount of capital, investing in an option at the peak of interest can result in a sharp profit loss. If you do decide to invest in a stock correlated to an option that’s been highly publicized, we recommend using a stop-loss order.
Rule #5: Limit the number of open positions you have
Managing multiple open options orders can be challenging — even for experienced investors. When you’re working on a limited amount of capital, opening too many positions can also limit your profits.
Whenever you think about placing a new buy order, ask yourself if it’s possible to take profits from 1 or more of your open positions. As a general rule, we recommend that new investors not open more than 2 or 3 positions at a time.
Pros and Cons of Low-Budget Options Trading
- Options trading requires a lower initial investment when compared to other investing strategies (like day trading or scalping).
- Most stock options allow you to execute the option at any time before the strike price. This can help you take profits should you need to unexpectedly close your position.
- If you’re betting against a stock, you can limit your potential losses by purchasing a put option. Other strategies like short selling can subject you to limitless losses.
- Stock options contain a limited time frame when they have value. This means that, if your contract expires out of the money, you’ll lose 100% of your initial investment. This is usually not the case with stocks, as assets rarely reach $0 in value.
- Options can show high volatility, changing in price by 90% in a single day. While this can enhance gains, it can also multiply losses.
Getting Started With Options Trading
Effective options trading begins with strong research. If you’re interested in learning more about the options market, consider checking out the top options trading alert services. Many of these are run by professional traders who send real-time notifications that will alert you of profitable options trades.