Top 10 Option Trading Tips

Option Trading Tip #4

My top 10 call and put option trading tips that I have learned, and that you MUST know before you start trading calls and puts.

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Trading Options Tip #4:

Know the Break Even Point of Your Option Trade Before You Buy It.

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Once you have identified a call option or put option that you are thinking of buying, the next step is to calculate the break even point on the option trade. To calculate the break even point, you must take into account the bid/ask spread and the commission charge on both the buy trade and the sell trade. You need to be confident that the underlying stock will move MORE than is needed to make the option price move more than the break even point in order to make a profit.

How to Calculate the Break Even Point on an Option Trade

When trading options, there are really 2 break even points that you need to be calculating. Short term option traders need to use the bid/ask spread and the commission rates to calculate the break even point. Option traders who are planning on holding the option to expiration need to calculate where the stock price needs to be at expiration to guarantee they have a profit.

For short term option trades where you are not planning on holding the option to expiration, you need to consider the following. To calculate the break even point, first note the difference between the bid price and the ask price. This is called the bid/ask spread. If the bid/ask spread is 10 cents and your commission is $10, then the option's bid price must increase 30 cents to break even if you just buy 1 contract (you will pay $10 commission to buy it and $10 commission to sell it and you have to overcome the bid/ask spread of $10 so you are starting out with a loss of $30). If you buy 2 option contracts, the the option's bid price must increase by 15 cents ($10 commission x 2, plus $10 bid/ask spread all divided by 2 contracts); and it must increase by 10 cents if you buy 3 contracts, etc.

If you are planning on holding the option to expiration, then your thought process and calculation of break even is different. Suppose General Electric (GE) stock is at $29 and the May $30 call option has a bid price of $1.50 and my commission rate is $10 per buy order and $10 per sell order. If I buy 1 contract the total cost would be $160 and I would need GE to be at least $31.60 at the May expiration to make sure it is in the money at least $1.60 which guarantees the option price would be at least $1.60.