7 Options Trading Mistakes Beginners Can Avoid
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Options are a great trading tool that can be utilized in all market conditions, either to generate income, produce profits, or hedge risk. There are several mistakes new traders make when they enter the world of options trading though. Options, when used incorrectly, can erode your account quickly, or in the worst case scenario create margin calls. Here are seven mistakes beginner options traders make, and how to avoid them.
1. Focusing on OTM Options
Out of the money (OTM) call or put options are typically cheaper, so many traders view them as a “good deal.” While this is true in some cases, options are priced in such a way that you aren’t going to get a free lunch. The premium, or value of the option when you buy it, decays with time. Therefore, the price not only needs to move above (for a call option) or below (put option) your strike price, but it needs to do so before the option expires, and by enough to offset the cost of the option.
It can be difficult to consistently make money with this approach. There are times when trading OTM options is a valid strategy, but don’t get caught in the trap of thinking that just because the option is cheaper it’s a better deal than another option. Assess the probability that the underlying asset will exceed the strike price before expiry, based on historical tendencies, before buying OTM options.
Be sure to read our guide Options 101: American vs. European vs. Exotic
2. Too Finite an Approach
Options are very flexible, and can be used in all market conditions. But not all option strategies work in all market conditions. When an underlying asset is calm and barely moving, buying OTM call or put options isn’t likely to produce good results as long as the underlying market remains flat.
On the other hand, writing covered options (when you have a position in the underlying stock and write options against it) in this environment can produce extra income for you. There are also other strategies that are more complex, such as Iron Condors, which involve taking multiple positions and producing a profit if the price of the underlying doesn’t move much.
Just like stock traders are taught to diversify, options traders should also diversify the methods used. Implement different strategies for different market conditions, and for different stocks or assets based on their tendencies.
3. Not Having an Exit Plan
A major error for new option traders, and traders in all markets actually, is not having an exit plan. When you take a trade you are expecting to make money, but how much money? How will you decide the amount of profit that is appropriate? If it looks like your option is going to expire worthless do you sell it beforehand to recoup some of the cost, reducing your loss? Will you hold the option until expiry?
See also 4 Ways To Exit a Losing Trade
These are questions that need to be addressed before the trade, not during. Create a plan for what a realistic profit target is, based on the historical movement of the underlying asset. Determine how you will minimize risk, and when you will exit the trade if it is losing and looks like it won’t finish in the money.
4. Oblivious to Market Moving Events
Say you create an options trade based on quiet market condition, and you’ll profit as long as the underlying asset stays docile. You’ll want to check to see if any market moving events are due out in the stock during the time frame of your trade. An earnings release for example could throw a wrench in your plan, increasing volatility, changing market conditions and putting your “quiet times” strategy unnecessarily in jeopardy.
Be aware of what is happening in the markets you are trading. Major economic events such as Fed minutes or an earnings release can change market conditions quickly, and your strategy should accommodate for that. Monitor the economic calendar and earnings calendar and create a plan for how you will trade around major news events. You may also opt not to trade close to these events, thus removing the big unknown of how the market will react to the event.
5. Ignoring Consistent Gains in Favor of Home Runs
Making a huge gain on a trade is a nice feeling, but it is also hard to do. In hindsight it is easy to spot the home run trades, but in real-time it is much harder. Much of the time stocks do nothing (or nothing major), and it isn’t easy to pinpoint when one of them (of the thousands available) is about to explode.
But markets constantly move several percentage points within a matter of days. Therefore, making consistent smaller returns can be easier than making one huge return. While making 2% a week based on a consistent strategy isn’t as sexy as a 20% return, you’ll likely be able to rack up multiple 2% weeks before ever capturing a big winner.
Also, remember that every time you make a small and consistent gain you are building your capital. This produces compounding returns. On the other hand, every time you lose on a “home run” trade you are diminishing capital, reducing the amount of capital available for trades. Over time this has a very negative effect because it becomes harder and harder to recoup losses as position sizes decrease due to diminishing capital.
6. Trying to "Time" Legged Trades
Option strategies often require taking multiple options positions at the same time. Such trades require several transactions, which should all occur at the same time to attain the desired positioning. Some traders will make the transactions one at a time though, attempting to increase their profit slightly by getting one option on an uptick and another on a downtick, for example.
The problem is that you may end up missing your window to establish the position. If the price begins to run before you have established your positions you may be left exposed to unknown risk.
If you’re creating a position that requires multiple option trades, take them all at once. Don’t try to cherry pick your entry points. Even if it works it will only have a negligible effect on overall profitability, and could mess up the original strategy if the price moves against you as you are awaiting a better entry.
7. Not Covering Written Options
Writing options is a way to generate income, as you receive the premium from selling the option upfront; if the option expires worthless you get to keep the entire amount received.
The premium is the maximum profit though, and if the underlying asset goes against you, you potentially face large losses (this is why most option writers have a position in the underlying asset as well, called covered option writing). The mistake of the option writer is failing to lock in some of the premium when they have the chance.
Don’t view option writing as gambling: “I hope the option expires worthless so I can keep the whole premium.” Be actively involved, and realize conditions can change. If the option is very likely to expire worthless (far away from strike price) then you can sit back and relax. But if the outcome is unclear, don’t be afraid to close out the position early.
If you sold options at $2.00 and can get out of the trade when the premium is $0.40 that means you still get to keep 80% of the original premium you received (less commissions) – you still pocket $1.60 multiplied by the number of shares of shares you wrote options on. Keeping 80% is better than potentially having to fork over cash (or your stock if the option is covered) if the price goes against you before expiry.
The Bottom Line
Options are a great tool, usable in all market conditions, but they can be disastrous if a trader doesn’t understand how to implement these financial instruments properly. Diversify your strategies and prepare for potential changes in market conditions that may be driven by major news events. Know how you will exit trades, and focus on consistent returns over home run trades. If your position requires multiple option trades, execute them at the same time; failing to do so may jeopardize the strategy. When you write options, don’t be afraid to exit the trade and keep part of the premium, especially if there is still a question as to whether the option will expire worthless or not.
Did you know that...
- Peter lynch, who managed the magellan fund at fidelity, believed in "buy what you know," investing in companies familiar to consumers?
- The 'risk-free rate' in finance typically refers to the yield on a 3-month u.s. treasury bill, representing the return on an investment with virtually no risk?
- 'window dressing' refers to the practice where fund managers buy high-performing stocks towards the end of a quarter to improve the appearance of their portfolio?
- Understanding and managing asymmetric risk involves evaluating whether the potential reward of an investment justifies its potential risk?
- 'front-running' is an unethical and often illegal practice where someone executes orders on a security based on prior knowledge of pending orders?
Quotes of the Day:
- "The best investment advice I can give is to invest in what you know." - Robert Rodriguez
- "The most important thing in investing is to have a clear understanding of what you're investing in." - Donald Yacktman
- "The investor's chief problem - and even his worst enemy - is likely to be himself." - Thomas Rowe Price Jr.
- "The best investment you can make is in a good education." - Leon Cooperman
- "The stock market is a great way to build wealth over the long term, but it is important to be patient and disciplined in order to achieve success." - David Tepper
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