9 Rules for Trading Options in a Changing Market

As a strength and conditioning coach once said, you can never be better than the fundamentals. If your fundamental form is wrong, you’ll hurt yourself and limit your progress.

The market’s strength coach, Federal Reserve Chair Jerome Powell, recently assuaged concerns that strong economic data had ruled out 2024 rate cuts. Animal spirits are once more bullish, but the market mob is as erratic as ever—and that makes it tough to have strong convictions about what happens next.

It’s a good time to review some options trading fundamentals. The market needs time to digest Powell’s remarks, so in lieu of making an investment recommendation that’s not backed by high conviction, let’s run through some important drills. Right now, it’s better to be more like a fox than a wolf.

1. When the market trend seems higher but is hostage to an event-heavy calendar, one- to two-week options expiration cycles are ideal. They maximize the ability to adjust positions in reaction to events because options contracts are highly sensitive to time and volatility.

2. Keep an eye on your profit targets. Review positions when profits hit, say, 70% of the target, and take profits at 80% to 90%. Great investors like Warren Buffett, who recently took profits on part of his massive Apple position, have a profit-taking discipline. There is an end in all things; respect it.

3. Position paranoia is 24/7. When money is at risk, obsess about risk. Roll strike prices up or down if profit percentages are hit before expiration. If a short put-option profit quickly reaches 80%, take profits and adjust the strike to keep the trade alive and to reflect the new stock price.

4. If a position moves against you—and a few positions are always out of whack—don’t fret. Never surrender control of your positions. You’re not losing money if you’re adjusting to a changing market. This is why rolling, or adjusting strike prices and expiration dates, is critical even though the act seems so mundane. You may have to roll a money-losing position for a few weeks before it is profitable again, or at least not in rough shape. Success is never guaranteed, but never stop fighting.

5. When the market mob is erratic and reactionary, short-term expirations let you adjust to volatile animal spirits. Keep the crazies on a short leash.

6. All ships at the bottom of the sea are filled with charts, but stock technical patterns are critically important. Charts instantly reveal stock trends. At a minimum, use the five-day simple moving average to illuminate what may influence a stock’s price trajectory during the options expiration cycle. Charts show resistance and support price points, and that offers a way to readjust strikes to maintain mastery of the situation.

7. Know which events are packed into an expiration cycle. Check the corporate investor-relations website for information on earnings, presentations at conferences, and dividends. Know economic release dates. If you don’t know what could impact your stock during the options trade, your fundamentals stink. You’re gambling rather than making decisions on probabilities. Too few investors understand this.

8. Options well bought are well sold. The most actively traded names often can be traded at market prices because spreads are a penny wide. Everything else merits limit orders. Try trading close to the middle of the bid-and-ask spread; that’s where fair value resides.

9. Nothing is static except for disciplined actions and probabilistic thinking. If you don’t get that, you don’t understand the options market, which is a problem for you because those who do live off those who don’t.

—

Originally Posted May 8, 2024 – 9 Rules for Trading Options in a Changing Market