The Price Tag Problem
Thomas Jefferson was reported to say, “Don’t buy something you don’t need just because it’s cheap.” This philosophy is true for clothing, knick-knacks, and option positions! Options traders, particularly novice traders or traders with limited capital, may be attracted to deep out-of-the-money options because of their low price tag. But with that low capital investment comes a low chance for success.
If an option is out-of-the-money, it has to move that much farther to become profitable by expiration. Contrarily, options that cost more (because they are in-the-money or have more time until expiration) have a greater chance of success. Risk will always correlate to reward, and when you try to swing for the fences, more often than not you wlll strike out!
Fear and Greed
These emotions are widely credited as a stock trader’s enemies, but the same is true for options traders. When a trade is winning, many investors cave to greed and are unable to close their positions for fear of missing up on additional upside. Greed can manifest itself on the way down as well, as investors refuse to admit defeat and instead hold on while their profits unfurl and losses build. Other investors may have the opposite problem, overreacting and bailing out of a position at the first sign of trouble.
The way to combat this is to have a plan before you even enter a trade. Look at the charts, consider your investment goals and risk tolerance, and select an upside target at which point you will close your trade. Also pick a bailout point for when you plan to cut losses. That’s the first step. The next step is actually sticking to this plan when your emotions flare up.
As aforementioned, you don’t want to commit more than 5% of your portfolio to any single option trade. But there is another way of thinking about this when it comes to stock versus options. If an investor plans on dedicating $50,000 of his position to Microsoft, he shouldn’t just buy $50,000 in MSFT options. Rather, he should buy the options equivalent of controlling $50,000 in MSFT shares (each option contract represents 100 shares).
For example, $50,000 would buy 1,500 shares of MSFT with the stock at $32. On the options side of things, 15 contracts of an intermediate-term (six-month), at-the-money (32-strike) MSFT call would be less than $3,000. This leaves $47,000 to invest in more conservative strategies or diversify one’s portfolio across different stocks or sectors. Spending $50,000 on 250 contracts puts is a hefty risk, and you could wind up losing it all.
Keep these pitfalls in mind and try to avoid them as you begin your new life as an options investor!