3 Options Trading Mistakes to Avoid
Options offer greater versatility and flexibility than stocks. With stocks, you are limited to buying when you think the stock will go up, and shorting (or selling, if you already own the stock) when you think it will go down.
While the basic trading actions on options are also buy and sell, the wide range of expiration dates and strike prices enable you to use them in different combinations to manage risk and increase the odds of making money. This is why options trading has become more and more popular with individual investors.
When used properly, options can be an excellent way to boost returns or hedge your portfolio. However, for beginners there are some common mistakes to avoid. Today I will discuss three.
1) Not Having a Plan
It’s normal to become emotional when trading. After all, we are all human. But emotions can cloud your judgment and cause you to make a move you might regret later. To keep emotions out of trading decisions, it helps to have a plan and stick with it.
Some simple but important questions you should ask yourself include:
- How much do you want to risk in each trade?
- What is your exit strategy?
- What types of stocks do you want to trade options on?
These are just three examples. There are many other questions you can ask yourself to help set up trading rules. No matter what rules you set, the key is to stay disciplined.
If you find success with the rules you set for yourself, great!
If you find that the plan isn’t working, then it’s best to adjust. Analyze your past trades and see where you might have made mistakes and try to make a better plan.
2) Risking Too Much or Too Little
This is related to the first question mentioned above. No one knows your personal situation more than yourself, so it’s important to know your risk tolerance.
Because there is a chance that you could lose a big percentage of your investment in an option trade, you should feel comfortable with the amount of money you are risking in that trade.
First, if you lose money that you cannot afford to lose, it could put you in financial hardship. Second, having more money at risk would also more likely cause you to let emotion influence your decision.
If you risk too little in a trade, you limit how much you could make, but clearly the consequence isn’t as bad as risking too much.
At the very least, thanks to recent commission reductions, the cost of trading an option has drastically fallen. Commissions won’t eat up your profits no matter what. Novices can use small trades to test strategies out.
One common rule to consider is to consistently invest a certain percentage of your account value or a certain dollar amount in a trade. Ideally, it’s a happy middle ground between greed and fear. You aren’t risking anything you can’t afford to lose, and you could get a meaningful return.
3) Not Paying Attention to Volatility
How much the underlying stock fluctuates can have a big impact on your option trading success.
You have probably heard of “implied volatility.” It’s a metric that reflects how quickly the market estimates the stock will move up or down. It’s usually baked into the option premium.
On some option trading software programs, instead of the words implied volatility, you may see the Greek symbol sigma (σ).
High implied volatility means that the market thinks there is a good chance that the stock will move quite a bit in a short amount of time.
As a result, the option premium will usually be higher for stocks with high implied volatility than those with low implied volatility. This is because the buyer has a better chance of making money with stocks that make significant moves.
A few words about long and short…
If you are long an option (you bought an option), time works against you. If the underlying stock price hardly moves, you probably won’t make a lot of money on the option trade. There’s a better chance you will lose money.
On the other hand, if you are short an option (you wrote an option), stocks that barely move work in your favor. Time value goes down every day. Ideally, the option expires worthless, and you just pocket the premium for nothing. The drawback, though, is that the premium on stocks with low implied volatility will be relatively low.
Keep in mind that implied volatility is called “implied” because it is a projection, not a fact. In reality a stock with high sigma may end up barely budging and vice versa, but the key point is that the information can help you determine if an option premium is cheap or expensive. You can also compare the value of sigma to see if it’s higher or lower than normal.
If an option premium is expensive, it may make more sense to write options. When the premium is cheap, it may be better to be a buyer.
Editor’s Note: Scott Chan just explained how to avoid three major pitfalls when trading options. Does uncertainty in the financial markets have you on edge? The key to mastering risk resides in what our colleague Jim Pearce calls “Mayhem Trades.”
Jim Pearce is chief investment strategist of our premium trading service, Mayhem Trader. Jim has developed an under-the-radar strategy to flip market mayhem into fast payouts. Want to learn more? Click here now.