Hopeium and Leverage Bedevil Options

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New option investors often see their great leverage and make the same mistakes time and again.

I’ve been trading and analyzing options since the early-1990s and at BigTrends.com we’ve been educating and providing specific trade recommendations since 1999. So we’ve seen it all, and have learned the most common mistakes traders make and the best ways to avoid those and get an “edge” over the markets.

First — Those who are new to options are immediately attracted to the very cheap “lottery ticket” type out-of-the-money (OTM) options.

By this we mean the options that are priced at 0.25 ($25) or below, for example. These are the OTM calls and puts that can potentially give very big gains, but have a low probability of success. These options tend to have a very low Delta (which is an option greek that can be interpreted as a probability of the option expiring in-the-money (ITM)).

Additionally these options have no “intrinsic value” and are 100% “time premium” — so you will lose value on them due to time decay as the clock ticks towards expiration. And you may also lose value due to decay in implied volatility, or Vega (another option greek).

So we tend to prefer ITM options. These generally have a lesser amount of time premium and implied volatility built into them and have a higher Delta. So basically you normally get more “bang for the buck” with an ITM option. Additionally your overall volatility should be less when trading these versus very cheap OTM options.

2nd — Traders enter positions without a game plan, or specific targets and rules for taking profits and limiting losses.

Again, we’ve seen this time and again and all traders have done this at one time or another in their trading accounts. They often let a winning trade turn into a loser, or let a small moderate loser become a big loser.

This comes down to discipline and having an organized set of rules. For example, if a trade doubles (goes up 100%), you may have a rule that you exit half of your position immediately, then you basically have a “free trade” on the remainder of your contracts.

You also could have specific targets for the underlying stock/ETF/security and when those are reached you exit part or all of your position, regardless of the price of the option. Another valuable strategy is to have a trailing stop-loss for winning positions, so that you can stay in the winners and let them run, but if it pulls back by a certain amount you still lock in your profits. Or you can have set rules such as taking partial profits at 25%, 50%, etc.

But the bottom line is that without having systems, rules, indicators, and discipline you are somewhat trading “blind”.

And for the losing trades … we’ve all had them. First, I’ve learned through experience that the best trades tend to go your way quickly. If a “perfect” setup is just sitting there and not going your direction, it may be time to cut bait and move on to the next opportunity.

Next we have the problem of “hope and wait” on losing trades (also known as “Hopeium”). This is how a small 15% or 20% loser can turn into a 50%, 75% or even 100% losing trade. And those can put a big damper on your portfolio and create a trading hole that you then have to dig out of. So limit your losses to small amounts. The goal in general is to have winning trades be two time to three times the size of losing trades, depending on the win/loss ratio of your strategy.

So have rules and discipline in place on your option trades. For example, have a specific stop-loss, or a technical indicator that when violated gives an immediate exit on the position. In general, having a clear trading plan with systems, rules, indicators and goals will provide a more confident and successful trading result over the long run.

Price Headley was inducted into the Traders’ Hall of Fame in 2007 and is the founder of BigTrends.com, which provides investors with specific real-time stock and options strategies and investment education to profit from significant market trends.

This article originally appeared on Traders Reserve.


Article printed from InvestorPlace Media, https://investorplace.com/2011/01/hopeium-and-leverage-bedevil-options/.

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