Trading options can be attractive for many reasons. Options can serve as a hedge against falling stock prices and can give traders the amplifying power of leverage, which can make options useful and lucrative in the right situations.
But traders can also abuse options and make common mistakes that derail their portfolios. Options trading is generally more complicated than stock trading, so you need to know a few important things before diving in. If you want to trade options, make sure you avoid these common mistakes.
1. Not having a trading strategy
Options trading has its benefits, but diving into it without any form of trading strategy is not a recipe for success. For example, how do you identify potential trading opportunities? What criteria will you use to determine whether a potential transaction is worth it? How much are you willing to lose on a trade that doesn’t go according to plan? These are important questions to answer.
If you don’t have a clearly defined options trading plan, you may make arbitrary decisions based on emotions or what you’ve heard in the news. When you have a trading plan, your decisions are simply based on whether an opportunity fits within the framework you have created.
Furthermore, inexperienced traders sometimes do not have an exit strategy, which can be a problem. Options can make big moves in either direction. You need to know not only how big of a move on your part to take action, but also how long you should wait before taking action.
2. Lack of diversification
One of the most common problems with options trading is a lack of diversification. When buying stocks, diversification usually means buying shares in many different companies and industries. When you think about options, it means something different.
With options you have more options than buying promising stocks and selling the losers. You have both call and put options, and many trading strategies and tactics to use them, such as covered calls, married puts, and bear put spreads. You can therefore tailor the option strategy to different situations.
Using multiple options strategies can also help you succeed even if a particular strategy is unsuccessful, and this diversification can be especially helpful because options can be an all-or-nothing bet. If you put all your money into one option position and it doesn’t work out, you’ll have no money left to trade with.
3. Lack of discipline
Options trading requires a keen sense of discipline and self-control. While it can produce profits faster than investing in index funds, that doesn’t mean it will always produce immediate results. If you want to do well, you have to be willing to stick to your strategy.
For example, options traders may sell a winner too quickly while holding a loser for too long. Or maybe they wait too long to buy back short options. Options require you to be smart about the way you trade if you want to be successful in the long term.
4. Using margin to buy options
Using a margin loan can be tempting when trading options because it allows you to make a nice profit without committing a lot of capital. The problem is that while a margin loan can increase profits, it does the same to losses. Buying on margin is risky, whether or not you use it to trade options. Margin calls are also a concern when trading with leverage.
It’s important that you don’t trade with money you can’t afford to lose, but trading options increase the chances of this happening. Because of the high risk associated with buying on margin, it’s like doubling your risk when you use margin to buy options.
5. Focusing on illiquid options
Liquidity is the ease with which something can be converted into cash. Shares of stock are often quite liquid, as they can easily be sold for cash when the market is open. But trading options is not as simple as selling shares at a certain market price.
Options traders are at the mercy of the bid-ask spread, the difference between what sellers ask for an asset and what buyers are willing to pay (bid). If there is a large difference between those two prices, you have an illiquid option. That means you may struggle to find a buyer for your option when you need to, which can be a problem given the sometimes rapid price fluctuations in options.
6. Not understanding technical indicators
When trading options, traders must understand the dynamics of option prices and how they work. For example, indicators such as an option’s delta, gamma, vega, and theta should be second nature to you. If you are not familiar with the “Greeks” of options trading, it is best to understand them before you start.
For example, Delta indicates how much the option price is likely to move based on a $1 change in the underlying asset. In other words, it tells you the price sensitivity of the option. Likewise, theta explains the effect of time on the option. An effective options trading strategy requires you to understand these various indicators so that you know how option prices will move in response to time, the price movement of the underlying stock, and the overall volatility of the market, among other factors.
7. Not taking volatility into account
As noted earlier, the options market can be volatile. However, smart options traders can use this to their advantage. A stock’s expected volatility affects the option’s premium, or the price the option trader pays for the contract. Understanding volatility can help you determine if an option is cheap.
Your trading strategy should take volatility into account so you know if a contract is worth buying. And if it’s not worth buying, then maybe it’s worth selling. Options can help you play the situation either way.
In short
Options allow traders to increase their profits, but they can be risky if you do not have the necessary knowledge beforehand. Like most things, learning curve options trading requires learning by doing. But if you keep these common mistakes in mind, you can make your learning experience cheaper.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
