A Billionaires 5 Rules for Options Trading

6/20/2013

I have been blessed in that I have worked for and had clients who were Billionaires. But there is one Billionaire I met during my hedge fund days that I will never forget, because he was one of the best options traders I have ever seen.

He had a 5 Step system for trading options that I use for my all my options trading today. I am going to share this with you today and I call this ” The Billionaires 5 Rules of Options Trading”

1) Never ever buy an Option (a Put or a Call) unless there is a catalyst or event. 
This means you only buy an option when there is an event that will dramatically move the price of the stock up or down. These events or catalysts can be anything from: Earnings Announcements, Fed Meetings, Economic Releases, an Activist Hedge Fund buying a stock to any type of corporate change, CEO, sale of a business unit, merger or acquisition. The key is to buy the option before this event occurs, you never ever want to buy an option after the catalyst or event. So in summary only buy an option when there is catalyst or event that will dramatically alter the price of the stock.

2) This Catalyst or Event must occur before the option expires.
An easy example of this is Earnings, you only want to buy an option that expires more than a week after the earnings date. Again this means when you buy an option make sure you leave yourself enough time so that your option does not expire before the catalyst or event occurs.

3) The Option must be Cheap.
This can be hard to measure but I like to keep it simple, I personally don’t like paying more than a $1 for any option. But if its a high priced stock, I will only buy the option it gives me at least 25 times leverage or more on the stock. Meaning divide the price of the stock by the actual option price. For example if the stock of XYZ is $100 do not pay more than $4 for the option on that stock, that’s the easiest way to make sure the option is cheap.

4) Only buy options in stocks that have low volatility.
This means you want to buy options on stocks that have moved sideways of flat for months at a time. Look at a chart if there has not been a significant uptrend or downtrend in the last 3 to 4 months, there is a good chance that the volatility in the stock is low and the options are cheap. Also if you have options software, you can compare the stock and its options implied volatility and underlying volatility to its historical implied and underlying volatility. This may sound confusing but its the same premise value investors use, they buy stocks when they are cheap in comparison to what they historically sold for, so you want to buy options when the volatility is low or lower than what it historically has sold for.

5) Only buy options if you can make 200% or more on the option.
This is very important, too many people buy options with no exit plan or profit target. You have to set a goal or sell point when you buy an option and to make it worthwhile from a risk reward standpoint. The option should have at least a 200% or more upside. Why 200%? because there is a good chance when you buy an option, you will lose the entire value or premium of the option (or 100% of your investment in the option) therefore to be rewarded for that risk you need to be able to make 200% or more in that option. Simply stated only buy an option when you have at least a 2 to 1 reward to risk scenario.

Now I will give you a real life example of an options trade I just made, where I only followed 2 of the 5 steps and it cost me dearly on my trade.

About two weeks ago I purchased a large quantity of put options on Silver, (The Silver ETF, Symbol SLV), that expired on June 28th. The option was very cheap I paid .$50 cents per option. So I followed steps 3 and 4, in that I purchased a cheap put option ($.50 cents) whose volatility was low, so the options were cheap not only in price but also cheap in terms of Silver’s historical volatility as well.

My big mistake though was not having the proper catalyst, I thought Silver was going to drop in price but I just wasn’t exactly sure why? I thought initially it would drop because the Job Numbers that were released 2 weeks ago would be strong and therefore would cause Silver to sell off. Also I thought Silver had broken a huge downward consolidation pattern and therefore it would drop 10% in the next couple of weeks.

Well the Job Numbers were good, and Silver sold off and I was up 100% on my Silver put options in 2 days, but instead of following the Trading Rules my Billionaire friend taught me, I took my 100% profit and went home.

Because of this I did not follow the 200% or more profit rule and I did not have the right catalyst, which turned about to be the Fed Meeting I therefore missed out on one of the biggest moves in Silver’s history, its 7% decline today.

By not following my Billionaire friend’s 5 Trading Rules for Options, I missed out a huge trade. I would have made 400% on my Silver Puts today instead of the 100% I made two weeks ago. So I learned first hand how much it can cost you by not following each and every one of the 5 rules above.

So my lesson to you is not only are these 5 Rules for Trading Options important, but even more important is that you make sure before you buy an option that you have followed each and every one of the 5 rules I stated above. Meaning do not buy an option unless it meets each and every one of the 5 rules.

To make it easy for yourself print out these rules and then before you trade an option make sure that you can check off each rule before you buy the option. If you do this I promise that not only will you greatly improve the success of your options trading but you will make a lot of money in the process as well.

Will Meade
President of The Billionaires Portfolio