It does not matter if you are just starting out in options trading or if you have experience from doing it for years. Everyone makes mistakes, and he or she are avoidable. However, you have to know what the mistakes are to make a plan so that you can avoid these mistakes. Take the time to learn from other people’s mistakes and make your own new mistakes that others can learn from.
Here is where we will discuss the top ten most common errors that an options trader can make and the ways that they can be avoided. By avoiding these mistakes, you are will want to make more informed trades and not worry about potentially putting cracks in your investment portfolio that you are going to have to fix at a later date.
- Start out with buying OTM (out of the money) call options:
This may seem like a good place for you to start when you are looking at options. All you are going to do is buy a call option and see if the one that you picked happens to be one that will give you a profit.
Using this strategy can seem like a safe option because it will match the pattern that you have been following as an equity trader; you’ll be buying low and selling high. However, the veterans of equity traders are beginning to profit from the same method.
But, when you buy OTM outright, you are going to find that it is hard to make money more consistently in the world of options trading. So, should you decide to limit yourself to this strategy alone, you are going to stand the chance of losing money on a more consistent basis and not learning from your mistake.
While it is tough to have the ability to predict which direction the market is going when you purchase stock, you are going to find that you are have to make sure that you are right about the direction in which the market is going when you are trading options. Not only that, but you will have to have the proper timing in purchasing the stock. In the even that you are wrong about the direction or the timing, then your trade could end up resulting in losing the premium that you paid. Every day that goes by where the underlying stock does not move, the option is going to begin to lose its time value until the expiration date is reached. This will be even truer if you find that you are on your first purchase, and it is a near term, out of the money option. This option is popular amongst the new traders because it is a cheap trade.
However, these trading options are considered to be cheap for a reason. In buying an OTM option, you are not going to get an automatic increase when the stock slides in the right direction. The price is going to be about the possibility of your stock reaching its strike price. If you get close to the expiration does not reach the strike price, then the stock will continue to move in the shortened timeframe will be low. So, the price of the option is going to reflect that probability.
Like any investment, buying options does carry with it risk, and in some markets, it carries significant risk. Some investors have a solid savings to fall back on in case the market turns and a large loss is realized. If you don’t have an emergency fund set aside, but you want to make the investment unless you have a structured settlement to sell (more info can be found here about structured settlements), you might be wise to sit out investing until you are in a position to be able to survive adequately should the worst possible outcome occurs.
You should think about selling the OTM option that you own. In doing this, you will be using a strategy that is known as “covered call.” In the selling of your call, you are taking on the responsibility of selling at the strike price that is stated within the option. Should the strike price be greater than the market price, then you’re going to be saying: should the stock go up to what cost is, then it is okay if your buyer takes the stock away from you.
By using this technique, you are going to be earning cash off of the OTM call that you sell. When you are bullish, then you are going to end up earning some income with your stocks if you do not care if you sell should the price happens to go up before the option expires.
The risk for covered call selling does not do not come from selling the option, but from owning it. There is a maximum potential for you to experience a loss of the call option. The cost basis of the stock is going to be less than the premium that is received for the call. Also, do not forget that you will need to factor in the commissions as well.
If you sell the call option, it is not going to produce a capital risk, but it will limit the upside for you, therefore, causing you to be creating an opportunity risk. You are going to experience risk by selling the stock upon assignment should the market rise and the option on the call is exercised. However, being that you do own the stock, there can be a bit of profit that is made because the price is going to increase to the strike price.
But, if the market remains flat, you’re going to be collecting the premium that comes from selling the call as well as retaining our long stock position. If you look at the other side, though, if your stock slides down, you want to get out, you have the choice to buy back the option and close out on the short position while selling on the long. Just keep in mind that you may experience some damage in your stock when the position moves to closed.
A smart strategy that you can use to continue to use the covered calls is to sell them. This is a low-risk strategy that will earn you some income while allowing you to familiarize yourself with how the options market works. In the selling of cover calls, you will be enabled to watch the options closer and see how the price is going to react to how the market moves over time.
- Using the “all purpose” strategy in various market conditions:
Options trading is a flexible trading choice.
While doing options trading, you will be able to trade effectively across a variety of markets in different conditions. Should you decide to take advantage of the flexibility, then you will need to stay open to learning new trading strategies.
The buying of spreads is going to allow you to capitalize on the different market conditions that you will run into. While doing this, you are going to need to remember that when in buying a spread, you are going to be buying it in the extended position.
If you are new in options trading, then you will need to familiarize yourself with the possibilities of spreads so that you can start to see when it is the proper time to use them.
The long position is made up of two different options. There is the low-cost option which is sold and then the high-cost option which is bought. Both of these options may seem similar with the same expiration date, number of contracts, security, as well as type. However, they will differ when it comes to their strike price. The long spread is going to be a call to a bullish position. These long ranges are going to consist of puts that are bearish.
In a spread trade, you buy one option at a time while you sell another one. The time decay may end up hurting one trade, but helping another. Essentially the effect of the time decay is going to neutralize the trade spreads versus when you buy individual options.
But, a downside in this strategy is that your potential is going to be limited. There are only about a handful of call buyers who can make a sky-high profit with their trades. A majority of the time, the stock hits a particular price; then they sell the option despite if they should keep it or not. So, if you are doing that, why not just sell the target when you enter the trade?
- Not having an exit plan before expiration:
It is likely that you have heard that you need to control your emotions while you are making trades.
While this may seem impossible because there will be moments that you get mad, the easiest way to control your emotions is to make sure that you stick to your plan simply.
While you are creating your exit plan, do not just plan for when you need to minimize the loss, you need to be sure that you have an exit plan for everything, including when everything is going your way. Along with having a plan for when things go down or when things are going right, have a plan for the timeframe for when you are going to exit the trade.
The most common thing for a trader to worry about is if they are going to exit too early. The best counter to this is to have a plan so that you can establish a favorable pattern for trading that will help to keep your worry in check. It doesn’t matter if you are buying or selling stock, you need to have an exit plan. Make sure that you determine what gains you will be satisfied with as well as ensure that you know the worst case scenario that you can put up with if you experience a loss. If you reach your upside goal, it is best that you remove your position and cash in.
Just make sure that you are not greedy when this happens. But, if you reach your stop loss, you will also need to clear your position. Make sure you are not exposing yourself to further risk by gambling that your option price is going to come back up. It is of vital importance for you stick to your plan once you make it! It is going to be tempting to deviate from the plan, but do not do it because your program is supposed to help keep the emotions out of your trading.
- Compromising the risk tolerance and making up for past losses by “doubling up.”
There are things that many traders say that they never will do, however, when you are backed into a corner because a trade is against you, you do what you have to do to get yourself out of the corner.
If you are a seasoned options trader, you may find that when you are faced with this situation, you are going to be tempted to break the personal rules that you have set into place. The best thing for you to do is to keep trading with the same option that you started with.
When you double up to catch up, you may have found a stock that you liked at ninety; then you will most likely love it at sixty. You may find that you are tempted to buy more to lower the net cost of the trade. However, be wary of doing this. It may make sense to you, but what makes sense in stock trading may not end up flying in the options trading.
The double up strategy many times does not make sense because options are considered to be derivatives which will mean that their prices will not move or have the same properties as their underlying stock. Time decay can be good or bad for the position of the stock, and it is always good that you factor in the time decay when you are making your plans.
Things are going to change as the market changes, and because of this, you are going to be tempted to do things that you have not done before. Before you make these decisions, stop and ask yourself if you would have made that decision when you first opened the option. If the answer happens to be no, then you probably should not do it.
This is the time that you should close the trade and cut your losses. The options are going to offer some real possibilities in leverage with a relatively small capital. But, there is the potential of it all blowing up should you happen to dig yourself too deep. It is better to take small losses when you get the chance so that you can avoid a catastrophe later on down the road.
- Trading illiquid options.
The liquidity is how quick a trader can sell or buy stock without causing a price movement.
The liquid market is a market that has many buyers and
sellers at all times actively waiting to buy or sell options. Another way to think about it is that liquidity is the probability that your next trade is going to happen at a price that is equal to the previous price.
Stock markets are usually more liquid than other markets since the stock traders are trading a single stock at a time. However, option traders could end up having dozens of contracts that they can choose from. A stock trader is going to move to a single form of IBM stock, but the option trader will have about six different expirations for the same stock as well as multiple strike prices that they can choose from. Having more choices is going to mean the market is not as liquid as the stock exchange.
The IBM is not a liquidity problem when it comes to option traders. The problem comes with the smaller stocks. In trading illiquid options, you are driving up the costs of doing business. Since the costs of option trading are high already on the percentage base, you shouldn’t burden yourself.
The rule of thumb for trading options is that when you are trading options, you should make sure that the interest that is open will equal four times the number of contracts that you happen to want to trade. Trade in your liquid options and save yourself from the costs and the stress that you are going to feel. There will always be plenty of liquid opportunities for you to pick up at a later date.
- Waiting to buy back short options:
The most valuable advice that you should remember about buying back short options is that you need to be ready to buy back any of your short options early. It is too often that traders end up waiting too long to buy back their options that they have previously sold. Just like waiting until the expiration date, there are various reasons that you want to buy it back. For example, you do not want to pay out the commission; you want to make a little profit out of your trade, or you think that once the contract expires, the stock will be worthless.
If your short option ends up being OTM then you have the ability to buy it back so that you can take the risk off of the table in a profitable way. Do not be cheap! A good rule of thumb for this technique is if you have the ability to keep about eighty percent or more of the gain that you started with from the sale, then you should consider the realization that you need to buy it back as soon as you possibly can. If you do not, then you are facing the fact that your option cane comes back and haunt you later if you wait too long.
- Not factoring in earnings or dividend payment dates in the options strategy:
You are not going to know when you need the earnings as well as the dividends dates for your stock, so it is best that you keep a log of it. For example, if you have sold calls and that there is a dividend quickly approaching, it may increase the probability that you need to be assigned early. This happens to be the case when your dividend is
predicted to be large. This is because the option owners do not have the right to a dividend, so, to collect it, a trader must exercise the option to buy the underlying stock.
Earnings season usually means that the options contracts tend to be pricier for both the calls and the puts. When thinking about it in the real world, the options will work as a protection contract. The contracts can be used to hedge the risk of any other positions.
The same principle will work with options during earnings season. Any pending news will produce volatility in the price. If you trade specifically in the earning season, this can be a fine strategy. However, be aware that there is some added volatility, and it will likely increase the options premiums. So, if you would rather stay clear, you might find that it is a better choice to trade your options after the market has absorbed the earnings announcement.
One of the best things that you can do is to steer clear of getting rid of contracts that have pending dividends unless you are okay with getting a higher risk of assignment on the contract. You need to know that the ex-dividend date so that it does not pass you buy. While trading during the earnings season, you will encounter a higher volatility in the underlying stock and end up paying a larger price for the option you are wanting. So, if you are playing on buying an option during the earnings season, an alternative would be to create a spread (buying one option while selling another). In the buying of an option that has an inflated price, the one you are selling is probably going to be inflated as well.
- Being unaware of what to do if you are assigned early:
When you sell options, you are going to need to remind yourself that you might be assigned. There are a lot of new option traders that never think about the possibility of being assigned until it happens. This can end up being a jarring event because they have not factored in the assignment especially if you are using multiple strategies on long and short spreads. When a first assignment happens, it can be emotional and even an irrational market event. There happens to be no reason as to why this happens; it just happens despite if the market is signaling that this is a dangerous maneuver.
The best way to combat an early assignment is to factor it into your plan at an early stage. If you do not, then you will end causing yourself to make an at the moment decision that can end up being less than logical.
At times it helps to consider the market psychology. For example, is it more logical for you to exercise an early call or an early put? Different things end up causing you to make this decision such as the fact that if you exercise a put, then you will sell the stock and get cash back. Then the question is going to become, do you want your money now, or later on when the option hits its expiration?
In exercising a call then the trader is going to end up being the one that is willing to spend the cash to buy the stock now rather than waiting till later. This is human nature to want to pay the money then. If the stock goes up, a trader who is still new to the game is going to jump in too early because they will not realize that they are leaving premium time on the table.
- Legging into spread trades:
If you want to trade a spread, you will not need to leg in. For example, you are buying a call, and then you try to time and a sell for a different call in the hopes of getting a gaining more out of the second leg. Many times the market will go down, and you will not be able to finish your spread thus leaving you with a long call and no strategy.
By using TradeKings spread trading, you can make sure that both legs of the trade that you are doing are sent to the market at the same time. The spread will not be executed until the net debit or credit has been reached. This is a smarter way for you to implement the strategy you want without taking the extra risk.
- Failing to use index options on neutral trades:
Any individual stock might volatile. When buying options that are based upon indices, you will be able to shield yourself from a huge move news items can create amongst individual stock. Here you might want to consider neutral trades on the bigger indices so that you can lessen the impact of the market news.
There are certain techniques that you can use to continue to turn a profit when the market is still. However, when the stock moves because of news, the move tends to be dramatic and quick, it is also not too uncommon for the stock to trade at a new level for a shortened period. An index move though is less dramatic and is not going to impact the as much.
Short spreads are made up of two positions that have two different prices, just like the long ranges. When the more expensive options are sold, then the cheaper option will be bought as well. Both legs of the trade have the same underlying security, a number of contracts, have the same expiration and are both going to be either a put or a call. Time decay effects will be reduced since one of the options was bought while the other one
The biggest difference between the long and short spread is that the short spreads will be more traditionally constructed so that they are not just going to be profitable in one direction, but will be when the underlying remains the same. Therefore, the short call spreads are going to be neutral in a bearish market while the short puts will be neutral in a bullish one.
Remember, the spreads are going to involve more than one trading option. So, make sure that you incure more than commission.