Before you begin trading options, there are several necessary (for you to become a profitable trader) steps to take. The following list is incomplete because there is more to trading options than the novice may anticipate. However, this is a very good place to begin.

The options world may seem to be quite simple - buy calls when bullish and buy puts when bearish and reap the rewards when your prediction is correct.


This is an illusion unless your predictions result in large price changes for the underlying security.  There is much more that you must understand about options before you have any chance of earning money.

The common factor among these concepts is education and gaining an understanding of how options work.

1. You must understand the nature of your investment. This seems trivial, but too many investors invest their cash because of something they heard or read - without making a serious effort to understand exactly how the investment is supposed to make money.

If you buy stock, understand the business. Do research and form an opinion as to whether the stock is worth owning at its current price and at this time. Whether trading individual stocks or indexes, become aware of exactly what the underlying asset is and what affects its price in the stock market. 

If you are not interested in doing detailed research, then invest in index funds (or ETFs) that match the performance of the entire stock market, or a specific segment of the market.

 

Trading the options on the individual stock or index is not the same as owning stock (you do not collect dividends, for example), but the profit/loss picture depends on how the stock performs in the marketplace. Your option strategy may be bullish, bearish, or market neutral, but before investing, make an effort to understand why you are willing to invest money on your expectation that the stock price will do as anticipated. 

Pay attention to when important news will be announced - such as quarterly earnings, FED meetings, and important FDA announcements. This prepares you for periods when the stock should become more volatile that usual. Do not be caught unaware of such important news events. 

Although it is true as a general rule - calls increase in value when the underlying  stock or index moves higher and puts increase in value when underlying stocks or indexes move lower - but there so much more than the stock price that affects the price of options in the marketplace that you must understand those factors.

One question that option mentors always receive from new option traders is similar to this: "I bought calls yesterday and earnings were announced this morning. The stock opened 10% higher ($33 when it closed at $30 yesterday). I lost money when the price of my calls declined. How is that possible?

It is possible (and predictable). To make money as an option trader it is mandatory that you understand why this situation is commonplace. The answer to the question is that the trader either bought options with a poorly chosen strike price (too far out of the money) and/or paid a premium that was just too high (implied volatility was too high). 

The educated trader avoids these traps

 

2. Understand how options work and which market factors affect their prices. 
First and foremost, options are derivatives and do not exist in a world by themselves. Their value derives primarily from the value of another asset.

However, the value (i,e., price in the marketplace) depends on much more than the value of the underlying stock (or index or commodity etc.) In fact, the market price of any option is determined by supply and demand, as well as six other factors. Those factors include:

• The type of option (call or put)
• Time remaining before the option expires
• The expected volatility for the underlying stock for a specific period of time (now until the option expires). (See #3 below)
•  The size of the dividend, if any
• The cost of borrowing money (i.e., prevailing interest rates)
• The strike price of the option

The good news is that this data is readily available (except for the volatility) and can be plugged into a calculator that uses an option-pricing model) to provide a very good estimate of the value of any option.

 

3. Know what Volatility is. it is impossible to overstate the importance of volatility when it comes to trading options.

Volatility  affects the price of your options in the marketplace. If you do not understand what implied volatility is and just how it affects the price of options, then you should not yet be using options. Learn and understand first; trade later.

The stock's volatility estimate drives option prices, The fact that this is true remains a mystery to the uneducated trader. Please believe me when I tell you that you cannot trade options with an understanding of volatility.

Additional information about volatility can be found here and here.