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Trading options can be appealing for many reasons. Options can serve as a hedge against falling stock prices or give traders the magnifying power of leverage, making options useful in the right situation.
But traders can also misuse options, and may make common mistakes that derail their strategy. Trading options is generally more complicated than trading stocks, so there are some things you should know before diving in. If you want to trade options, be sure to avoid these common mistakes.
1. Not having a trading strategy
Trading options has its benefits, but diving in without any sort of trading strategy is not a recipe for success. For example, how will you identify potential trading opportunities? What criteria will you use to determine whether a potential trade is worth pursuing? How much are you willing to lose on a trade that doesn’t go according to plan? These are important questions to answer.
If you don’t have a clearly defined options trading plan, you might end up making random decisions based on emotion or what you heard in the news. When you have a trading plan, your decisions are based simply on whether an opportunity fits within the framework you have created.
In addition, inexperienced traders sometimes don’t have an exit strategy, which can be a problem. Options can make big moves in either direction. You should know not only how large of a move should trigger action on your part, but also how long you’ll wait before taking action.
2. Lack of diversification
One of the most common problems when trading options is a lack of diversification. When buying equities, diversification usually means purchasing stock in many different companies and industries. When thinking about options, it means something a little different.
With options, you have more possibilities than buying promising stocks and selling the losers. You’ll want to deal with both calls and puts, for example. You also have many trading strategies and tactics, such as covered calls, married puts, and bear put spreads. Using multiple options strategies can help you succeed even if one particular strategy is unsuccessful.
3. Lack of discipline
Options trading requires an acute sense of discipline and self-control. While it can provide wins more quickly than investing in index funds, that isn’t to say it will always produce immediate results. If you want to do well, you must be willing to stick to your strategy.
For example, options traders can be too quick to sell a winner while holding onto a loser for too long. Or perhaps they wait too long to buy back short options. Options require you to be smart with how you trade if you want to be successful in the long run.
4. Using margin to buy options
Using a margin loan can be tempting when trading options since it might allow you to make a nice profit without putting up much capital. The problem is that while a margin loan can amplify the wins, it does the same with losses. Buying on margin is risky, whether or not you use it to trade options. Margin calls are also a concern when trading with leverage.
It’s important that you don’t trade with money you can’t afford to lose, but trading options increase the likelihood of that happening. Because of the heavy risk associated with buying on margin, it is usually best left to advanced investors.
5. Focusing on illiquid options
Liquidity is the ease with which something can be converted into cash. Shares of stock are often quite liquid since they can easily be sold for cash whenever the market is open. But trading options isn’t as simple as selling shares at a given market price.
Options traders are at the mercy of the bid-ask spread, the difference between what sellers are asking for an asset and what buyers are willing to pay (bid). If there is a big difference between those two prices, you have an illiquid option. That means you might have trouble finding a buyer when needed, which can be a problem, given the occasionally rapid price swings with options.
6. Failing to understand technical indicators
When trading options, traders must understand the dynamics of option pricing and how they work. For instance, indicators such as the delta, gamma, vega and theta of an option should be second nature to you. If you aren’t familiar with these, it’s best to understand them before getting started.
For example, delta represents how much the option price is expected to move based on a $1 change in the underlying security. In other words, it tells you the price sensitivity of the option. Similarly, theta explains the effect of time on the option. An effective options trading strategy requires that you know how to read charts and understand the various indicators they show.
7. Not accounting for volatility
As noted earlier, the options market can be volatile. However, savvy options traders can use this to their advantage. The expected volatility of a stock influences the option’s premium, or the price the options trader pays for the contract. Because of this, understanding volatility will help you determine whether an option is cheap. Your trading strategy should account for volatility so you know whether a contract is worth buying.
Options allow traders to magnify their gains, but they can be risky if you don’t have the necessary knowledge beforehand. A lack of knowledge could result in key mistakes, such as not having a trading plan, a lack of diversification, or relying too heavily on margin. Like most things, there is a learning curve with options trading that requires learning by doing. But keeping these common mistakes in mind can help make your learning experience a less costly one.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.