7 Basic Option Trading Rules

1) Be Patient: This is my most important rule. Decide how much you are willing to risk in options over the next twelve months. Don‘t commit all your money right away. Spread your money and trades over an entire year.

Obviously, the more funds you have available, the more you can devote to buying options. As a rule of thumb no more than 10% of your total funds should be used for buying options.

2) Diversify: Don‘t put all your eggs in one basket. Take at least two or three positions, and buy at least four contracts per position to reduce commission costs.

Try to invest the same dollar amount in each position, to eliminate the risk of having small investments in the winners and big investments in the losers.

Also, buy puts and calls on several stocks. Market variability is a major risk of option buying. If you buy calls and the market declines, you could be wiped out. You should always have some bets for both bullish and bearish scenarios.

3) Taking Losses: Generally you should sell a losing option if it drops by 50%. Take your loss and move on. The ability to cut losses is a key determinant of whether you will be a successful trader or not.

You need to aggressively protect your profits AND cut your losses when you have them, too. In fact, cutting losses is more important.

The big hits that you get with your winners should offset your losses. But they will only do this if you keep your losses as low as possible.

Most investors have a hard time taking losses but you must take the same kind of "mechanical" trading approach to losses as you do with winners.

4) Taking Profits: When we tell you to "take profits," we mean that you should close half of your position when the option hits its target price. Then let the rest ride for possible future gains. Then after selling half, if an option you are "riding" begins to lose value, immediately close the position and take the rest of your profits.

The easiest way to monitor this is with the underlying stock. If the stock reverses direction by 3%, close your position. You should also do this with options that have gains but have not hit their target prices.

5) Don't Plunge: As you start trading remember that the biggest error novice players make is that they overdose and put too much money in the market at one time. Veteran traders don't make this mistake. Draw up a game plan with which you spread your purchases over several months or more and diversify your positions.

Be patient and only play with money you can afford to lose. The options market is open every business day of the year. If you can't place a good trade today, there's always tomorrow.

6) Take in Easy: If you are a new options trader you will need to build up some experience. Depending on your personality you may want to use this training time to "paper trade" where you only follow the recommendations and do not actually invest any money. Or you may prefer to invest a small amount of money to get started. Use this "training" time to build up experience before you actually invest money.

Our recommendations give you all the information you need to place your order. All you have to do is decide how many option contracts you want to trade and then read the information to your broker.

7 ) Your Game Plan: This final key to success separates more players from their money than any other. The pros never disobey their stop losses. Discipline is critical when you trade options. Sure, at times you may take profits too early or cut losses too early. But in the long run following your game plan will pay off and may save you from trouble.