Introduction:
Betting on the movement of the stocks of listed companies is, by far, one of the most profitable ways to generate returns on capital. For instance, the stock of the electric vehicle maker, Tesla, rallied by at least 650% in 2020, generating returns of up to 7 times investor capital.
However, for some categories of sophisticated investors, the returns on stock investing may not be ample enough. Also, some other investors have a higher risk appetite, which the actual stock market may not be able to fill. These investors, therefore, then go through other means such as derivatives trading, to get their desired returns. One of those means is option trading.
Options Trading and Benefits
The benefits of options trading are copious. For one, the returns from a rightful bet on a stock are magnified by high degrees. In the actual stock market, investors can only make money when prices of securities go up. With options, on the other hand, traders can short stocks and, therefore, make money when their prices fall.
However, just as options trading can multiply the returns on a rightful bet, it can also aggravate the losses on a wrongful one. It is not uncommon for options traders to lose all of the capital in their trading accounts. Nonetheless, becoming quite profitable at options trading is possible and achievable. One of the most important steps to take on the way to becoming a profitable trader is to develop a trading strategy.
Importance of an Options Trading Strategy
The role that developing an options trading plan plays in making profitable traders cannot be overemphasized. Whenever traders set out to make bets in the market, they usually have at least two goals in mind – the first which is to make money; and the other which is to avoid losing their risked capital. A trading strategy helps you achieve these, and it does this in a variety of ways, including the following:
- Reducing Emotions
Trading with emotions is one attribute that causes heavy losses to any trader. The human emotions that can greatly affect trading include greed, fear, and sometimes, hope. Greed causes a trader to take extraordinary risks that can lead to heightened losses. Then, fear also prevents a trader from taking advantage of profitable market opportunities.
Having a plan that is strictly followed greatly prevents traders from being driven by these emotions.
- Enables Traders to Take Advantage of Market Opportunities
An indisputable quality of financial markets is that past events always repeat themselves. That is why many traders only trade patterns, that is, technical analysis. A trading plan in place will facilitate the taking advantage of these patterns whenever they appear, and deter traders from going after the wrong trading opportunities.
How to Go About Developing a Trading Strategy
There is no holy-grail strategy in the markets. Different strategies are meant for different purposes. Discussed here are the components that we recommend should be part of your trading plan:
- Entry Strategy
This is one of the most important. While trading opportunities abound in the stock market, traders still record recurring losses because they have not developed systems to aid their trade entries. For instance, a basic trading tenet is not to enter a LONG (Buy) trade at market peaks and to wait for a retest instead. An entry strategy will guide a trader as to how to enter the trade when a retest indeed occurs.
- Exit Strategy
Equally important is the exit strategy. Traders can make money with a good entry but lose it all or even end up in negative due to a poor exit plan. A good exit blueprint will enable a trader to close both profitable and losing trades at just the right time.
- Money Management
A good trader with excellent entry and exit approaches can still lose extraordinary amounts if such a trader does not manage risks properly. Hence, it is important for a risk management plan to be in place. While traders can make a lot of money trading options, they can still lose most or all of their capital if they do not put the right plans in place, and stick to them. Following these steps is a good start.