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Lessons from the Pros

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Keep Your Option Trading Simple

Mon, Aug 25 2008, 05:53 GMT
by Online Trading Academy Team

Online Trading Academy

There are tons of option strategies. Why so many? Simple, it's because most option speculators can't figure out price direction . Instead, they rely on these complex option strategies and a variety of standard pricing models that don't work and simply add illusion to a constant simple reality of all markets, supply (resistance) and demand (support). When we filter out illusion and replace it with pure supply and demand analysis in options trading, we not only simplify the useless complexity of options, we discover endless low risk / high reward opportunity based on a set of objective rules.
This opportunity is one in which the reality based options speculator simply derives his or her profit from the illusion or emotion based options speculator.

An Observation

I have been trading and providing trading education for many years. One of the most important lessons I have learned is that most people can't follow simple rules. I can hand someone quality trading tools and a mechanical set of rules on a silver platter but if the foundation of their trading belief system is faulty, they will not be able to follow or execute the simple rules. The problem is that they succumb to illusion filters they don't even know are present. These illusion creators can come in the form of lagging indicators and oscillators, market or economic news, so-called professional's opinions, green and red candles on your price charts, complex option strategies and so on. This leads to falling for what I like to call, "the illusion trap". Option traders who fall for this trap over and over make two consistent mistakes. First, when they buy call options, they buy after a period of buying. Second, they buy calls at or near price levels where supply exceeds demand. Conversely, they buy put options after a period of selling and at or near price levels where demand exceeds supply. The simple laws of supply and demand ensure that the buyer and seller of anything who consistently takes this action will lose over time. To not only avoid this trap but also take advantage of it, a simple shift in perception to what is real is what is needed. Crossing this bridge of truth can lead to a monumental shift in options trading performance.

The Proper Foundation

In my humble opinion, the two most important tenets of a proper foundation in trading anything are the following:

1) The movement of price in any and all free markets is a function of an ongoing supply and demand equation. Opportunity exists when this simple and straight forward relationship is "out of balance". In other words, we want to enter a position in a market when price is at a level where supply and demand is out of balance and exit that market when price has moved back to a level where there is relative supply and demand equilibrium.

2) Any and all influences on price are reflected in price. In other words, price charts alone give us all the information we need.

As long as these two tenets are the foundation of your trading belief system, you are likely headed down a path of objective information that offers consistent low risk / high reward opportunity. When the novice market speculator turns to conventional technical or fundamental analysis for price direction answers, they are met with illusion traps that may only add more layers of questions and complexity.

Discipline and Rules are Key

Objective rules are very important but without the discipline to follow your rules, the rules will not help. For those who have discipline, here are rules that will likely help your options trading reap low risk / high reward gains.

Remember:

As price nears demand (support):

1) Calls become cheap but are about to become pricey.

2) Puts become pricey but are about to become cheap.

As price nears supply (resistance):

1) Calls become pricey but are about to become cheap.

2) Puts become cheap but are about to become pricey.

Rules:

1) Identify the nearest demand level below current price.

2) Identify the nearest supply level above current price.

3) Measure the distance between the demand and supply level and determine whether or not there is a desirable profit margin. (for more information on this, see my prior SFO or Online Trading Academy articles)

4) If and when price revisits a demand level, the option buyer can look to buy "at" or "in the money" calls. The option seller can look to sell (write) over-priced puts with a strike just at/below the demand level and take advantage of inflated put premium.

5) If and when price revisits a supply level for the first time, the option buyer can look to buy "at" or "in the money" puts. The option seller can look to sell (write) over-priced calls with a strike just at/above the supply level and take advantage of inflated call premium.

Create a Path For Others to Follow, Don't Follow a Path

Instead of using conventional trend analysis to identify that a trend is well underway, use objective supply and demand analysis to anticipate the next trend. Instead of noticing high volatility after it is already high, use simple supply and demand analysis to anticipate when volatility is likely to increase. The key to any type of trading, especially options, is to take action just before everyone else does. Never forget, the only way you can derive a profit trading anything is if others are willing to pay more than you paid, after you buy. Therefore, the key to low risk / high reward trading is to be first in line, at the right time.

It's Not Easy

The greatest flaw of the human mind is that it poses the ability to deceive itself through two filters, one is "illusion" and the other is "emotion". In the options markets, identifying traders who take action based on illusion and emotion is very simple if your analysis is reality based. Knowing where demand (support) and supply (resistance) levels are is the key to predicting future price movement.
Predicting future prices movement in underlying markets offers the OPTIONS trader a tremendous edge.

Published on  Mon, Aug 25 2008, 05:56 GMT