1. Buying Out-of-the-Money Options
A lot of new traders like to start out by buying near term out of the money options. Why? They are the cheapest so it seems like a great idea at the time. The problem is that these options are cheap for a reason. They have a small probability of finishing in the money so they are not going to be worth anything to begin with. Think of these options as lottery tickets. You will have to buy lots of them just to get one to pay off and break even.
When you purchase these options, you HAVE to be right in both timing and direction. Now that seems natural and obvious at first, but if you are sitting on these options for too long, then a move in the right direction still won't help you out. The closer those options move to expiration the lower the probability becomes that they will finish in the money which means they will still be worth very little.
When purchasing straight long calls and long puts try to get them at the money or in the money. The options will be more expensive than their out of the money counterpart but the probability of success and the leeway they afford will be worth the money. If you still want to go out of the money then shoot for one strike out of the money.
2. Getting Over Leveraged
When starting into the world of options you will undoubtedly come from trading stock first, this is just the natural progression. As a stock trader you probably have rules for how big of a position you are going to trade. Typically traders will buy in blocks of shares: 100 shares a position, 200 shares a position, etc... and spend anywhere between $1,000 - $5,000 on a position. The problem forms when they try to make this move into options. Options, by their nature, are cheaper than stock so it will allow you to take on more shares for less money then you are used to. This leads to getting over-leveraged in these positions. If you are used to spending $1,000 for a position buying the same amount in options will leave you will much more leverage and risk. The swings in options can make or break a position very quickly and if you are not use to the swings then you can end up in a lot of pain.
When you start trading options, try to keep your position size small. In fact, one of the best things about options is that you can still be profitable by trading only one contract. Commissions are typically so cheap you don't need to trade large positions to break even. Anytime you are learning a new option strategy or play always start small so you keep your risk low. Use small positions to learn how options move with the market, volatility, and time. Once you have a clear understanding of the types of plays you are running then you can begin to build your position size.
3. Not Having A Plan
Option trading is a lot more complex versus trading regular stock positions. There are a lot more factors to watch and there are a lot more options to take when you are already in a position. The nice part about options is that you will rarely want to simply enter and exit a position. There are a lot of adjustments that can be made that will allow you to capture some profit or reduce your risk.
When you trade without a plan, you will enter a position and then have it move against you which will leave you frozen like a deer in the headlights. When trading without a plan, you let emotion take over your decision making. It is impossible to leave emotion out of trading but allowing it to make the decisions for you is a great way to blow out your portfolio.
With all trading, stock or options, you need to set a plan before you enter the position. This plan should include when you are getting in, the strategy you will use, what your profit target is, adjustment levels are, the adjustments you are going to make, and your max loss. Now, this may seem like a long list to prepare before even making the trade but having this plan ready will keep you in the game longer. Kirk at OptionAlpha.com reaffirms that the three numbers you need to know before you click send on a trade are: the percentage profit target, adjustment points, risk and maximum loss.
Have you thought about when you are going to adjust a position? Will you adjust when a stock reaches a certain point when you are a percentage away from your max loss like we describe in our Iron Condor Trade, or will you do it when the deltas reach a certain point? These are the things that need to be planned before you reach that level. Let me tell you from experience if you wait until you are already underwater in a position your emotion will take over and you will make poor decisions about the trade.
As you progress in your trading and learn more about options some parts of this plan will just natural fill in itself. Certain types of trades lend themselves to having the same types of adjustments done at various levels, but when you are first starting these items need to be detailed out.
4. Limiting Yourself To Simple Long Call and Long Put Strategies
When you first start trading options you will, inevitably, start with long calls and long puts for stocks you want to trade long and short. There is nothing wrong with that. Your first trade should not be an Iron Condor. The problem is that traders will allow themselves to get pigeon-holed into this strategy and never venture out into other strategies, which is a real shame because options allow for so many unique strategies that you cannot get with stock.
Only with options can you trade an upward move, downward move, a move in either direction or no move at all, an increase in volatility, drop in volatility, or just a passing of time. To not explore these strategies would be a tragedy because you will be short a lot of useful tools in your trading toolbox.
Now, not all option strategies will be for you. There are some plays that we do not enjoy running or have no luck with, looking at you calendar spreads, so don't run them. It didn't hurt to know about them and tried them in the past.
Begin your journey into new option strategies by first studying them and then trying them out in small sizes. As we mentioned in the Getting Over Leveraged fix, option commissions are cheap and they allow you to trade small sizes without raising your breakeven point. You never know when you will find your next favorite option strategy.
5. Trading Options Without Fully Understanding Them
Here is the story we hear from most new traders, "I bought a call on XYZ and then XYZ moved up in price but my call lost money. I don't understand, what went wrong?" Most beginning option traders will find themselves in this situation and the answer is always the same, "volatility dropped". This is a perfect example of the pains involved in not knowing about the inner workings of options.
You don't have to know every minute detail about every option trade before you start trading but you better know something. Start by Downloading Our Option Trading eBook. This will give you a good start as it details out every option strategy available and how they react to volatility, time, and direction. Now when you place a trade you can use it as a quick reference to make sure you are not surprised after the trade is already on. Once you have a good idea of how the strategies work start to dive into the Greeks. The Greeks can and will be confusing but a basic understanding is needed to understand how your strategy will move. The Greeks should be learned in this order: delta, gamma, theta, and vega.
6. Letting Short Options Go Unmonitored
Short options carry with them several interesting properties. One of the most notable and usually the head scratcher is the fact that short options have limited rewards and unlimited risk. Now this is usually a turnoff to most option traders, but don't let it stop you from exploring these strategies. Short options can be a great way to generate income but you have to stay on top of them.
This doesn't just relate to monitoring the downside. The upside needs to be watched too. Options traders will push to squeeze every dime of profit out of a trade only to have it turn on them and have it end up a loss.
Remember when we talked about Not Having A Plan well this is not where you want to break that rule. Your first and most important rule is to never let short options go in the money unless you are trading covered calls or using puts to pick up stock. If you are not running those strategies and let the option go in the money you run the chance of getting assigned and this is not a good situation if you are not seeking it. Before you begin to trade short options set your get out points whether that is dependent on a technical analysis or a max loss number. Make sure you don't make these 5 mistakes when shorting options.
7. Not Being Informed
Not being informed of market events is a problem not only for option traders but for all traders in general. What happens is they find this perfect trade, dot their i's cross the t's, but forget to account for one variable that ruins the whole trade. With option trading these mistakes can be magnified and can cause a play that should profit to turn a loss instead. Most traders are aware that company earnings will affect a trade but what about dividends? A company coming up on their ex-dividend date can cause short options to be assigned.
When you are in the market, you need to be dialed into what is going on both from a macro and a micro standpoint. From a macro perspective, you should always keep your eye on an economic calendar and look for any significant economic news releases that could affect the overall market. A couple of items you want to keep your eye on are employment numbers, GDP numbers, and whenever the Federal Reserve talks.
Looking more into the company, at the micro level, we want to focus on any scheduled announcements. As mentioned above, short options have a higher probability of being assigned when a company reaches its ex-dividend date. This is because option traders have no rights to the dividend so they must convert to stock to get that dividend.
You will want to keep an eye on earnings announcements too. When a company releases earnings, it can send the stock roaring or tanking. This uncertainty causes volatility to increase which in turn increases option prices. This will also lead you to experience volatility crush after the announcement which can drop the option price dramatically.
It is okay to trade around these events, but you need to understand what they are and the effect that they could have on your strategies.
8. Trading Illiquid Or Low Volume Options
Liquidity is how fast you can get in and out of a position at a desirable price. The lower the liquidity, the higher the chance you won't get a price you like or you will have to wait an excessive amount of time before you do. This also has the effect of increasing the spread size between the buy price and the sale price. If you purchase an illiquid option you could begin the trade down 10-20% right from the start. That is not something you want to have to work back from just to turn a profit.
Not all options are created equal. Unlike straight stock where you always trade just the company common stock, options have a wide variety of choices. Only on one company, you are faced with several expiration dates that could venture out three years (as is the case with LEAP Options) and a multitude of strikes both on the put and the call side. A lot of options are just not going to trade, and you don't want to get caught in that position.
Just because the options are listed on the screen doesn't mean they are liquid or good to trade. Most options won't be traded. The smaller the company, the more illiquid options it will have. The further out of the money and in the money you go the more illiquid the option will be.
There are two numbers you want to focus on before you decide to purchase or sell an option. The first is Open Interest which will let you know how many open contracts are on that strike. Each strike will have its separate open interest, and it will fluctuate daily depending on the trades placed. Avoid strikes with little to no open interest.
The next number is Volume which is precisely like stock volume in that it tells you how many shares have been traded that day. Again, you will want to focus on option strikes that carry some volume. The higher these numbers are, the more liquid that strike is and the easier it will be to trade at prices you desire.
What mistakes did you first make when you started trading options? Let us know in the comments...