Trading options is one of the greatest ways to grow your wealth while also hedging your risks. It’s worth pointing out that options are also known as derivatives because they derive their values from underlying assets. And with the derivatives market adding up to a total of around $1 quadrillion, it makes sense why trading options is becoming increasingly popular.
And while trading options is one of the less risky ways to make money from speculation, it’s not without its pitfalls. But by knowing what the common option trading mistakes are, and how to avoid them, you’ll be better prepared to increase your chances of success.
Interested in learning more? Continue reading and we’ll walk you through everything you need to know!
1. Not Having a Goal In Mind
When you enter into an options trade, no matter how complicated or simple it is, you should have a clear goal for trading and exit plan in mind. This, of course, comes after learning the fundamental strategies.
An example of something simple would be selling a covered call against a stock position that you own. The goal of this trade could be something along the lines of, the call will expire worthlessly and I’ll keep the premium.”
You also need to have an exit strategy that you’re ready to utilize whether or not the trade goes your way. Let’s look at the covered call example above. If the trade works out in your favor, then the exit plan would be to simply wait until the expiration and then write another covered call.
For more complicated trades, there are obviously going to be a variety of different situations that could happen. So your exit plan should be much more complex than the simple example.
However, no matter what, having an exit plan and clear goals are important to locking in your gains and mitigate your losses. Really what you’re doing is taking emotion out of the equation.
2. Doubling Down on Losing Trades
This is a mistake that every options trader commits at least a few times. And it really comes to a lack of discipline. If you execute an options trade and the price of the stock starts to move in the opposite way that you were hoping it to go, then it may be tempting to put even more money into the trade in a hope to get even.
This is especially true when the trader is simply purchasing call options. For example, if you buy $50 call options on a $55 stock, and the stock falls to $45, you might be tempted to add some out-of-the-money calls to the position. After all, the options are most likely cheaper right now, and if you liked the stock at $55, then it probably appears really attractive at $45.
Purchasing options that are out-of-the-money is hardly ever a good idea. This is especially true when you’re adding in even more money than you originally planned.
3. Misunderstanding Leverage
Many novice options traders misuse the leverage factor that option contracts offer. These traders don’t understand just how much risk they’re actually taking.
Often, these traders are attracted to purchasing short-term calls. Because this is so often the case, it’s worth asking: Is the outright purchasing of calls a “conservative” or a “speculative” option trading strategy?
Let’s look at an example. Imagine John finds out about options trading and has $6,000 in his account. He finds a stock that’s trading at $60 per share.
If he buys 100 shares of stock, that will be $6,000. He then notices that the call option is trading for $3. And that call option represents 100 shares.
So we’re talking about $300 for one call option. John notices that he has enough money to buy twenty contracts.
Now, let’s talk about Peter. Peter also has $6,000 in his account.
Peter decides to buy one of the at-the-money 60 strike call option. He spends $300 of his $6,000.
So there’s a lot of difference between what John and Peter are doing. Peter has limited his risk to that $300.
Peter has increased his risk and now has a decaying asset. He could lose his entire investment if the stock doesn’t go anywhere over the life of the option contract.
So how can we trade smarter?
If you usually trade 100 shares of stock, you should start out with purchasing one option contract. The capital involved in buying one option contract will be your total risk. Only after you start having success at this kind of size should you consider choosing position sizes of larger amounts.
4. Choosing the Wrong Time Frame
The biggest thing about options contracts is that they have a time component. An option that has a longer time frame will cost you more than one with a shorter time frame. That’s because there’s more time available for the stock to move in the anticipated direction.
Unfortunately, many traders find cheap front-month contracts to be irresistible. However, it can be disastrous if the shares don’t move in a way that accommodates the expectation for the option purchased. Some traders also find it to be psychologically difficult to handle stock movements over longer timeframes.
Understanding how timeframes affect the values of contracts and your risk tolerance will help you make better trading decisions.
Make Sure to Avoid These Option Trading Mistakes
As we can see, trading options can be a lucrative business. However, it’s crucial that you look out for the common option trading mistakes and do your best to take emotion out of the equation.
If you’re looking to become a successful options trader, then contact us today and see what we can do for you!