Last Updated on September 26, 2023
Investing is one of the best decisions you can make for your finances. If done right, it can lead to financial independence and might even allow you to retire early.
But how do you invest? Options trading is one of the most lucrative investment opportunities, even if you’re a beginner with little experience. However, as with all types of investments, there are risks.
The interesting thing with options trading is that you can earn a decent profit even with small capital. You just need to follow the rules and understand how the market works. And that’s what we’ve done. We curated seven important rules you need to follow for options trading.
Can You Start Options Trading With Little Capital?
Options trading is one of the most favorable trading options when it comes to small capital. These trades are essentially contracts to buy or sell at a future date.
If the prices aren’t favorable, you can back out. Therefore, investors with small capital aren’t locked into a particular asset. In some ways, starting with a small capital is better than jumping in with lots of money – especially if you’re new to investing and options trading.
The only thing is that you’ll need to keep tabs on your trades. It’ll teach you to be diligent and intentional with your decisions. New traders who start with a lot of capital often spread themselves too thin, taking excessive risks early on. Sometimes even without completely understanding how the market works. Therefore, small capital keeps you from making impulsive decisions.
Understanding the fundamentals is the key when trading with little capital. Chuck Hughes has fantastic resources where you can learn options trading intuitively. The resources are broken down to make the information digestible for beginners.
7 Rules to Follow When Options Trading With Little Capital
When trading with little capital, you must make the most of every dollar. Options trading can be incredibly financially rewarding. However, many beginners often find themselves making crippling mistakes. This could be because they try to over-optimize their limited capita, leading to missed opportunities. Or, they put all their money in high premium options in hopes of massive returns. Here are seven important rules to start options trading with little capital.
Understand What You’re Getting Yourself Into
Before you start dreaming about making millions of dollars from options trading, understand the market first. Options trading is incredibly technical, and you need to put some effort and time into it.
Learning the basics will give you a good foundation. In options trading, you’re investing in the future value of assets. It’s a contract. And someone on the other side who enters the contract will also expect to make a profit.
Remember that you will lose money in some trades and sometimes make a lot. Understanding the landscape and how it works is crucial for building fundamental skills.
Options trading has a very short shelf life. It’s very unlike investing in stocks. Therefore, you don’t want to put all your money on a single trade. This rule is especially important for new traders starting with little capital.
Don’t put most of your capital on a single or a handful of trades. This will increase your risk significantly.
There is no successful trader out there who has never suffered a loss. Losing trades is common in options trading. Honestly, all investments come with inherent risks.
The idea is to minimize risk and maximize reward. This is why it’s important that you understand position sizing and avoid allocating all your money to a single trade. Beginners are particularly vulnerable to this. You might see a very enticing option contract and think it has much potential.
Here’s the thing: you’ll get more opportunities to trade high-value assets in the future. At the moment, it’s best to allocate your money prudently since your capital is low.
Don’t Be a Bandwagoner
Speaking of very lucrative one-off options, it’s most likely not a good investment. Beginners often tend to fall into hype and trends. A trending stock might be hyped up by a positive news cycle. However, it’s hard to determine how stable it’ll be in the long term.
The best strategy is to do your own research. Learn how to analyze the news to extrapolate what the true value of an asset is. Understanding how to research and analyze the news will make you more independent.
This means that your chances of being misled by the market will be very low. Although, it can be difficult to accurately analyze the news when you’re a beginner. Moreover, you might want to save as much since you’re working with low capital, which could lead you to miss potential opportunities. So, having a mentor also helps in this case.
Specify Holding Periods for Trades
When you’ve held a position for a long time, the chances of getting returns from that trade are far less. So, set a maximum holding period.
Successful traders play the long game. They aren’t phased by the idea of making a loss on a couple of trades. On top of that, they have the experience to know that holding a position too long decreases the chances of a profit.
As mentioned earlier, the shelf life for securities in options trading is very short. Many beginner traders make the mistake of holding a position for too long, hoping to make a profit out of it eventually.
The maximum holding period for securities should be between 3 to 7 days. Yes, it’s that short. You need to get comfortable cutting your losses. Otherwise, the sunk cost fallacy will cost you a lot.
Trading Options Has No Space for Gambling
Options trading isn’t gambling. There’s technique, skill, and market knowledge involved. To become a successful trader, you need to avoid gambling. Make informed and well-thought-out decisions.
Don’t take risks when you aren’t sure of the potential reward. That’s an easy shortcut to losing all your money – especially when you’re a beginner. Calculated risks are different, though.
Another kind of trade you want to avoid is one that has unreliable factors. Go for securities that are not that volatile. You must also consider the interest rate, reward-to-risk ratio, and the asset’s underlying price.
Being able to accurately calculate the risks of a trade will keep you from making bad decisions. There are a couple of ways to gauge a trade’s risks.
You can use a risk graph, look at past trends, or use the gamma to track rate changes.
Calculate Target and Stops
Target prices and stop losses are tools investors use to maximize profits and minimize their losses. Therefore, calculating the target and stops for all your trades is a very important rule. It’ll keep you proactive.
A target is essentially the best price a security or stock will reach. When the asset reaches its target price, investors will sell it. This strategy ensures you get the maximum profit.
Whereas a stop loss is a minimum price limit. It’s a tool that helps you minimize losses. When you have a stop loss, you can protect your finances by selling the stock when it reaches a certain bottom threshold.
Stop losses are particularly useful when you can’t always monitor your trades. For example, if you’re on vacation, you can use option calculators to calculate the target price and stop losses in advance.
However, when you’re starting as a beginner, keep an eye on your trades all the time. Even when you have pre-calculated target prices and stop losses. It’ll teach you to be diligent.
Don’t Invest in High Cost Options
It might be tempting to trade options with high returns initially. However, most of those options also come with high premiums. This will eat into your already small capital.
You don’t want most of your capital tied to one trade when you have little capital. Start trading with low-cost options. Then, when you’re making profits, you can invest some of the returns into buying high-premium options. So, always look for options with low to reasonable premiums.
Is Option Trading Easy to Start With a Small Capital?
The steps are the same regardless of how much capital you start trading with. So, how much capital you invest initially doesn’t matter. Here’s how you can start trading options:
- Step 1: Open an options trading account
- Step 2: Pick the options and securities you want to trade/buy
- Step 3: Predict the strike price
- Step 4: Decide on the time frame
Additionally, a lot of beginners don’t do a proper personal financial analysis. This is a big mistake. So, even before you start options trading, put yourself in the right mindset.
As previously mentioned, learn about the market and how it works. Also, clearly define how much capital you want to start trading with. Having a maximum capital cap will keep your finances safe. You can increase your capital by gaining more experience (and profits).
Types of Options
Two major types of options are calls and puts. Calls give you the ability to buy a security at the strike price, while puts give the investors the right to sell a security. Both of these need to be done before the expiration date.
With a call option, you can buy an underlying security, although you aren’t obliged to buy it. However, if you buy it, you must do it before the expiration date. Call options, therefore, rise in value as the underlying price of the security rises.
You can sell the underlying security at the strike price with put options. It also needs to be done before the expiration date. Put options gain value as the price of the security decreases.
There are no shortcuts for financial independence. While option trading is very lucrative, you must have the right mindset and set goals. Small starting capital isn’t going to be an issue here.
You just need to use your capital smartly. Keep these important rules in mind. Additionally, it’s important to learn more about trading and the best strategies. It’ll keep you ahead of your competitors. And with enough knowledge and experience, you can make sizable profits.