Options trading isn’t difficult once you understand the basic concepts. They provide great opportunities when you use them correctly and can be dangerous when you use them wrongly.
You could make a profit no matter if stocks go down, up, or sideways and these great possibilities could lead you to make mistakes in options trading. Despite the fact that this sounds great, you could also lose everything you invested in options trading. And you can do that in a short time.
Do you want that? Of course not. No one wants to lose money. So, what do we have to do?
It is important to understand where mistakes in options trading can come from and how to avoid them. The truth is that even the most experienced traders can make mistakes in options trading. They can misunderstand some opportunity, have less caution, literally almost any absence of focus may cause mistakes in options trading.
We will examine the most frequent mistakes and how to avoid them and, also, how to overcome them.
These mistakes are typically made by beginner options traders. So, take time to evaluate them and you can avoid making costly wrong actions.
What mistakes can you make in options trading?
Mistake 1: You don’t plan your entries and exits
Options trading is more complicated than trading stocks. When you enter the position in options trading, there are a lot more elements to watch and be aware than it is the case when trading stocks. In options trading, you cannot just enter and exit the position. You have to make a lot of adjustments if you want to profit and decrease the risks involved.
So the first mistake in options trading is to trade without a plan. This means you’ll enter the position and what is next? What are you going to do? Will you let your emotions to handle your trading? What if the price move against you? Will you pretend nothing is happening and like a child you’ll close your eyes until all problems go away?
Of course, we know it’s impossible to put emotions out. But, also, we know that you can’t allow your emotions to affect your trading decisions. If you do such a thing, your portfolio could blow out and you’ll end up in losses.
How to avoid a Mistake 1?
Simply, trade smarter. It’s easy to say but how to avoid mistakes in options trading, particularly this one?
Start to plan your exits. Exits are not important just to reduce the losses when things are not going in your favor. You must have an exit plan, in any case, you shouldn’t even enter the position before you have a good exit plan. Your upside exit and downside exit points must be set in advance. That means you already know the price targets. Further, a time frame for each exit is important too so you have to plan it.
Keep in mind that options are time decaying assets. As the expiration date nears, the scope of decay grows. For example, if you are a long call or put and your expectations are more likely not to happen in the expected time frame, get out of the trade. Don’t wait, just go on to the next one.
Time decay will not always knock your trade, of course. For example, if you sell options without having them, time decay will work for you. You’ll have a winning trade if time decay erodes the option’s price. You’ll keep the premium for the sale. Yes, that will be all you’ll earn if you are a short seller of a call or put option. The bad thing is that you may expect a great risk if the trade goes wrong.
So, it isn’t a matter of what do you like or not, what strategy you’re running. You MUST have an exit plan for each trade. Even when you have a winning or losing trade. If your trade is winning don’t be greedy and don’t wait around for more. Exit with profit. If it is the opposite and your trade is losing, don’t wait also because you’ll need to exit the losing trade. Waiting with the hope that losing trade will turn into your favor is too risky.
With having the plan, when you know your entry and exit points you’ll profit more consistently, you’ll reduce your losses.
Mistake 2: Using only the long call and long put strategies
The important element when starting to trade options is to have a vision for what is possible to happen. In other words, you’ll have to estimate but also, your estimation must be accurate. You can use technical and fundamental analysis or a mixture of both. By using technical analysis you’ll have an interpretation of the volume and price in the charts, also you’ll look for support and resistance zones, trends because you would like to recognize opportunities for buy or sell. Fundamental analysis will show you a company’s financial audits, performance data, and current trends so you’ll be able to view the company’s value.
While estimating the different options strategies, you have to be sure the strategy you pick is created to take advantage of the outlook you suppose. You have to decide which is most suitable for your current situation.
If you limit your trades to long call and long put strategies you’ll limit the probability to use some more profitable strategies. Moreover, they are unique, for options only and not implementable on stocks.
How to avoid mistakes in options trading?
In trading options, you can trade an upward as well as downward move, a move in each direction, or without movement. Besides, you can trade, for example, an increase in volatility, or a decrease in volatility, etc. Is there any reason why shouldn’t you use some of these strategies and add them to your trading toolbox?
Of course, not all options strategies will be good for every trader. There are some trading strategies that you don’t enjoy running. Maybe you didn’t have luck with them in the past. It isn’t necessary to use them but it can be useful to know them. Just try out the new strategy in a small size. That will not increase the cost per trade but new strategies might be interesting but most importantly, maybe you’ll find your next favorite strategy.
Mistake 3: You wait too long to buy back short strategy
This strategy can turn into a great mistake. You must be ready to buy back short strategies early. For example, if a trade is going in your favor it is easy to love the fanfare, but the trade may easily turn in a different direction.
We have heard numerous explanations of why traders are waiting too long to buy back options they have sold. Some were betting the contract would expire worthlessly, some didn’t want to pay the commission to get out of the positions, or were just greedy hoping to get more profit out of the trade. The list of excuses is very long.
How to avoid all mistakes in options trading?
When a short option gets out-of-the-money and you want to buy it back, just do it. Don’t hesitate.
There’s a rule-of-thumb. If you can maintain to hold 80% or more of your original gain from the sale, think about buying it back quickly. Contrarily, a short option will come back and hurt you if you wait too long to close the position.
Let’s say this way. For instance, you sold a short strategy for $2 and, for example, a week before the expiration date, you have an opportunity to buy it back for $1. Take it! Quite rarely it will be worth an additional week of the risk.
Mistake 4: You are buying out-of-the-money options
This is common for new traders. We almost all tried this in the beginning. The reason is obvious. Out-of-the-money options are the cheapest and it looks like a great plan to start with them. Well, they are that cheap with a great reason and we understood that later. These options have very little chances of ending in the money. Most frequently they end up worthlessly. Trading these options is more a lottery game where you have to buy numerous tickets to see one that pays off and break even.
When you buy these options, you must be accurate in timing and direction both. Even if you hold these options longer, a move in the right direction will not help you out. With approaching expiration, there is less possibility for these options to end up in the money. It’s more likely they will remain cheap.
How to avoid this mistake?
Try to get long calls or long puts at the money or in the money. That will increase their value since the options will be more costly than the out-of-the-money equivalent. So the probability of success will increase and it will deserve money.
Mistake 5: Trying to overcome the past losses by doubling up
All traders have certain absolute rules. They are playing well unless a trade turns against you. That experience is common for every single trader. Almost everyone was faced with a trade that turned against expectations. The first reaction is to break all adopted trading rules and continue trading the same option they started with.
Have you ever heard a saying “doubling up to catch up?” But it falls into stock trading. For example, if you bought the stock at $50 and you loved it, you’ll still love it at $30 because the lower price will give you a chance to buy more shares. This isn’t relevant in the world of options trading. It can be one of the great mistakes in options trading.
How to avoid this mistake?
This strategy called doubling up isn’t suitable for options trading. Don’t use it. Keep in mind that options are derivatives and that their prices don’t move the same direction as the underlying stock.
Yes, this strategy can lower your cost per contract for the entire position, but it can compound the risks. So when a trade goes against you, just ask yourself: “Is this a trade I would like to execute?” So, what to do in this case. Simply close the trade to cut losses and find another opportunity. To say this simply, it is smarter to take a loss now than wait and have bigger losses later.
Everyone can make mistakes in options trading. They can be costly especially if you are trading cheap options.
Never think that cheap options can give you the same value as low‑priced options. Cheap options might have a bigger risk. You can lose everything you invested in them and more. the lower the likelihood is that it will reach expiration in the money. Before taking any action try to understand where the mistakes in options trading may arise.