Trading options can be appealing for many reasons. Options can serve as a hedge against falling stock prices and give traders the magnifying power of leverage, making them useful and lucrative in the right situations.
But traders can also misuse options and may make common mistakes that derail their portfolio. Trading options is generally more complicated than trading stocks, so you must know a few key things before diving in. If you want to trade options, be sure to avoid these common mistakes.
7 mistakes to avoid when trading options
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.
The best options brokers offer tools that can help you determine the best options strategy based on how you think a stock will perform.
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 have both calls and puts, and many trading strategies and tactics to use them, such as covered calls, married puts and bear put spreads. So you can match the options strategy with a variety of situations.
Using multiple options strategies can also help you succeed even if one particular strategy is unsuccessful, and this diversification can be especially helpful since options can be an all-or-nothing wager. If you put all your cash into one options position and it doesn’t work out, you don’t have any more cash to trade with.
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, and they require active trading and vigilance.
If you’re more of a buy-and-hold type of investor, it could make much more sense to purchase the best long-term investments and then add to them over time.
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’s like you’re doubling your risk when you use margin to buy options.
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, which is 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 for your option when needed, which can be a problem given the sometimes 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 the “Greeks” of options trading, it’s best to understand them before getting started.
For example, delta represents how much the option price is likely 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 and how much an option’s price will decay with the passage of time.
An effective options trading strategy requires that you understand these various indicators so that you know how options prices will move in response to time, the price movement of the underlying stock and the overall market’s volatility, among other factors.
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. So 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. And if it isn’t worth buying, then maybe it’s worth selling instead. Options can help you play the situation either way.
Bottom line
Options allow traders to magnify their gains, but they can be risky if you don’t have the necessary knowledge beforehand. Like most things, options trading requires learning by doing. But keeping these common mistakes in mind can help make your learning experience a less costly one.
— Bankrate’s James Royal contributed to an update.
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.
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