The 7 biggest mistakes options traders make and how to avoid them. By Zach
I’m going to let you on in a little secret. The early days of options trading can be rough and when I started, I lost a lot of money. And I mean, a lot of money. Those days are, thankfully, long gone, but when I look back, I realise that a lot of the mistakes I made were inevitable because of inexperience. In fact, I keep on seeing new traders make the exact same mistakes, time and time again.
Shorten your learning curve. Here are seven of the most common errors.
Mistake 1. Putting All Your Eggs in One Basket
I don’t care how great a trade set-up is, don’t ever over expose your account – EVER…
We can have the best set up in the world, but stocks can go up as well as down, and if an unforeseen news item affects a stock, (e.g. management stealing from the company, etc.) you could lose 100% of what you invested in the position.
Remember, trading is a marathon, not a sprint.
You need to keeping your position size in check on every trade to ensure you survive. That means on average 5% – 10% of your account in any one position. For really good setups you may allocate a higher amount, but should never exceed in more than 15% in one position.
If, for whatever reason, the trade doesn’t work out and you lose 100% of your premium, your account should still be intact. A sure thing doesn’t exist. Don’t bet everything on one position.
Mistake 2. Not Giving Yourself Enough Time
Buying options which are about to expire is very tempting. It makes sense – they are cheap and if the underlying stock does what you think it is about to, you could be making enormous profits – right?
Well, it’s unlikely. The institutions (big banks, hedge funds and so on) are on the lookout for amateur traders who are playing right into their hands. They’re waiting to take your investment from you in those imminently expiring options.
They can move the underlying stock very easily to suit their own aims, and we see it time and time again at options expiry each month. So until you are experienced in trading, stick to options which are not going to expire for at least two to three months. You have to give your trade time to play out.
Sure, when you’ve got experience under your belt, there are occasions when you can buy the near-term expiry, but it is not often that those opportunities occur. Experience will tell you when that will be, so for vast majority of trades… give the trade time to play out. Don’t let the institutions take your money!
Although these options might be more expensive and your prospective gains smaller, there’s a better chance of the stocks moving in the direction you need them to, and less risk of losing your money.
Mistake 3. Buying Options Which are ‘Out of the Money’
If the options you’re buying currently have no intrinsic value – for example, you have call options at the $110 strike price, when the underlying stock is at $100 – we refer to this as being “Out of the money”. These options are of course cheaper and so you might think that it gives you a chance to make bigger profits, but again, be careful…
Options that are ‘out of the money’ will decay in value, and very quickly, especially so if you have the near-term expiry. So until the underlying stock reaches $110, and in fact moves beyond than that, your option’s value will decay to zero.
True – if it does get well above $110 you could win big, but the risks are huge.
Even if the stock does rise, it might not do so as quickly as you think – it might not happen until after your options have expired. And during that entire period, your option will not give you any profit until the underlying stock gets above not only the strike price, but the premium you’ve paid for them as well.
I’d recommend only buying options that are ‘Out of the Money’ if you go for the longer- term expiry. You need to give that underlying stock a chance to reach $110 and beyond. Apart from anything else, too much volatility in your account is no good at all for your morale… So stay away from these options.
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Mistake 4. Ignoring the Market
You can be absolutely confident that a certain stock is going to go up, but if the markets are trending in the opposite direction, chances are you’ll still suffer – at least in the short term.
Remember, you want the wind in your sails… So always try and match your trades to the direction of the S&P 500.
As the old adage goes, ‘A rising tide floats all boats’!
Mistake 5. Getting Too Greedy
Quit when you’re ahead! If your underlying stock has a big day and your options go up in value – take the money and move onto the next trade.
The temptation to cling on for more profit is always there and I’ve felt it myself. But I can’t count the number of times I’ve been up substantially yet taken a loss because I held on, looking for even more profit.
This is a particularly common problem among new traders who aren’t confident in their ability to find another good trade setup. If they see something going in the right direction they cling on in the hope it will carry on forever.
Mistake 6. Following the Analysts
When you’re not quite sure what you’re doing with options trading, it’s tempting to take the advice of someone who you think knows better than you, the analyst on TV or in the paper. Here’s a secret – the experts have their own agendas. Don’t trust what they say. Instead, learn to read the charts yourself.
Markets are forward-looking. They tell you tomorrow’s news today, so if you know how to read the charts, you’ll have an enormous advantage, and won’t have to rely on analysts who have their own interests at heart, not years.
Mistake 7. Investing Too Much at the Start
When you start out trading options, you will suck. Sorry to be blunt, but it’s the truth!
So start off with a nominal sum and practice. Find your feet and get used to all the emotions you’ll feel as the market moves both in the direction you want – and against you. When you know what you’re doing, it will be time to invest more.
And just to reassure you, there is massive profit to be made in options. It’s worth mastering!
What are the biggest mistakes you’ve made so far? Drop me a line and let me know.