Your goal as an options trader is to move the odds in your favor wherever possible to ensure the success of your trades. Everyone likes to talk about their successes, but it’s really the mistakes that teach us the most.
Even professional traders have taken a lot of lumps in their careers, so let’s review some of the most common (read: most costly) mistakes that people make when trading options. I hope this will save you a lot of time, money and frustration as you embark on your options trading journey!
1. Don’t Trade Willy-Nilly – Have a Strategy for Profits
Why do traders get into certain stocks (or their options)? Well … most of them don’t have any idea. And when you don’t have any idea why you’re getting in, you’ve got no edge and, thus, no strategy for getting out with profits.
Stocks are volatile and move for a number of different reasons. They are also impersonal — meaning, they really don’t care if you own them or not. For the most part, stocks will be around for a long, long time and can typically be closed whenever you want, for some value.
Meanwhile, options expire and these trades either win, lose or break even on your investment. Even though you should be playing the options game with your “funny” money — i.e., what you can afford to lose — many traders forget that they’re still playing with real cash.
Options are much more volatile than stocks, so a strategy is especially critical, especially in unpredictable markets where the trading landscape changes in the blink of an eye and profits can quickly become losses.
2. Don’t Put too Much Money Into One Trade
Options are not long-term investments — they are calculated tools that provide immense leverage. But, this leverage can work both ways, so make sure to never risk more in any one option trade that you wouldn’t be OK with losing if the trade turned against you.
Remember, one option contract enables you to control 100 shares of the underlying stock, so even if a contract might cost $50, if you normally buy five or 10 contracts, you shouldn’t buy 20 or 30.
It might seem like you’re shopping at your favorite wholesale club, but if that trade turns against you, you’re placing $1,500 at risk. That might not seem like a lot of money, but if you’ve shorted a call — which gives the call buyer the right to purchase stock at the option’s strike price — and you aren’t in possession of the underlying stock, you could find yourself scrambling to get 3,000 shares to turn around and sell.
Suddenly, that inexpensive option doesn’t look so cheap anymore!
3. Don’t Overpay for Options
Sometimes options can be priced just right. Other times they seem downright cheap, yet in some other situations they can be trading at a steep premium. How do you know if the “price is right” for a particular option?
Options can be an inexpensive way to play a big-name (and oftentimes big-ticket) stock, as one options contract that controls 100 shares of stock can seem like pocket change in comparison. However, you have to be extra-careful when volatility levels in the markets spike. Option premiums go up during these times but then pull back as investors gain more confidence.
When you pay too much for an option, it just takes a little adjustment to this volatility to whack the price down (even when the underlying stock doesn’t move that much). Keep tabs on the Chicago Board Options Exchange’s Volatility Index (VIX) and its CBOE Nasdaq Volatility Index (VXN) — the higher the volatility numbers, the greater the fear out there and, thus, the higher the option premiums.