When you first got started trading stocks, it might have felt overwhelming. It takes time to discover your trading identity. What works for some traders might not work for others. However, as you advance along your journey you’ll discover that equities are just one way to play the stock market.
If you’re brave enough, you’ll take the time to discover options. But trading options is not easy. In fact, they are leveraged products that can be risky if you don’t take the time to learn how they work. Do your research to understand the ins and outs of options to avoid common options trading mistakes. If you’re able to master the fundamentals and strengthen your options knowledge, you could be able to turn a small sum of money into a fortune. Moreover, you need to fully understand the four common options trading mistakes that can ruin your options account
There are several reasons why you should consider getting involved with options if you have never done so. These reasons include leverage, improving odds, reducing risk, and versatility. With options, you can use less capital to achieve greater returns.
For example, 100 shares of Apple at the price of $188 would run you $18,800. For some traders with small accounts, investing in high-dollar stocks is just a poor use of capital. However, you can buy an at-the-money Apple call option expiring in 30 days, which could be as much as 98% cheaper than owning 100 shares of the stock. You see, one call option leverages you 100 shares of stock, giving you greater bang for your buck.
You Can Be Flexible with Options
You can structure certain option trades that heavily shift the risk vs. reward balance in your favor. When you buy options, your risk is limited to the premium spent on those options. During periods of uncertainty, like an earnings or FDA release, holding stocks might bear too much risk. But with options, you can define your risk making them a suitable alternative.
Options also give you flexibility. With stocks, you are mainly making a directional trade. However, with options, you can make volatility bets, play for ranges, as well as bet on how high or low stock will or won’t go. Traders looking for greater versatility will find comfort in what options can offer them.
As great as these benefits sound, you’ll have to be patient when learning to trade options. If you jump right in, you’re bound to make one of the avoidable options trading mistakes many beginners make. Making too many of these mistakes can damage your trading account pretty badly. Kyle Dennis and Jeff Bishop know these pitfalls well and have learned along the way how to avoid them. Take advantage of the learning opportunities both of these successful traders offer to better avoid making options trading mistakes.
Kyle Dennis runs Kyle Dennis’ Biotech Breakouts (biotechbreakouts.com). He is an event-based trader, who prefers low-priced and small-cap biotech stocks. He’s also using his knowledge and looking to multiply his capital through options trades with his tested I.G.N.I.T.E strategy.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options, and leveraged ETFs.
4 Options Trading Mistakes That Can Ruin Your Account
Let’s jump into the common options trading mistakes you might make in your career if you don’t prepare yourself against them. Remember that everyone makes mistakes — even professionals — and you shouldn’t throw in the towel just because you’ve tripped up and lost some money. Get up, dust yourself off, and treat your mistake as a learning experience.
That being said, the more you do your homework, the better equipped you’ll be to make smart decisions and avoid these four options trading mistakes:
Not Learning The Basics And Jumping Right In
It’s easy to know the value of a stock position: Take the stock price and multiply it by the number of shares. However, options are more complicated than that. It can be frustrating for those who don’t understand how options work. Sometimes you can buy a call option and the underlying stock price can go higher but the value of those options can actually decline.
You see, the value of an option is not solely based on the price of the underlying stock. Other factors include volatility, time to expiration, the option strike price, and the risk-free interest rate. Take the time to learn how these factors play a role in the price of an option.
You don’t necessarily need to be an expert on option Greeks, but knowing Delta, Vega, and Theta will help you advance further.
For example, with options, you can express a bullish bias in many ways. You could buy a call, sell a put, or buy a call spread, just to name a few. If options are relatively cheap, you can probably get away with buying calls. On the other hand, if the options are expensive, you might opt for buying call spreads. Knowing about implied volatility can help you make those decisions easier.
New options traders often get caught up in all the cool things they can do with options without bothering to learn the basic option principles. Although it’s good to be excited about your trading, making decisions without a foundation of knowledge beforehand is one of the options trading mistakes that takes out many newcomers to the game.
Be patient, and work on building your foundation first. If you don’t learn the basics, you could potentially ruin your options account.
Always Swinging For the Fences
It’s true — you can triple or quadruple your returns or more with options. However, too many new option traders get caught up in the allure of hitting that home-run trade that they are always swinging for the fences. Instead of hitting that grand-slam, new traders strike out. Being overzealous in your deals is another big options trading mistake that can seriously damage your portfolio.
For example, buying deep out-the-money options that expire in less than a week might be attractive because they are “cheap,” but they are cheap for a reason. Option market makers are not dumb — if something looks too good to be true, it probably is.
If you’re constantly putting yourself in low-probability trades you can’t expect to have great results. Sure, there is a time and place for buying lottery tickets, but it can’t be the only strategy you have.
Think of it like this: Penny stocks are cheap but that doesn’t mean they are all worth buying. You have to be strategic and know when to take your shots. Never just trade options to trade because this could hurt your options account.
Just because there is an option on a stock, it doesn’t necessarily mean it’s tradeable. You’ll want to pay attention to the options volume and open interest, in addition to the bid/ask spread. Slippage can be a very serious problem if you trade a thin option. If an option is thinly traded, you might be forced to lift the offer on when you enter and hit the bid on the exit. It puts you at a disadvantage and further from breaking even.
Sometimes, it makes more sense to play the stock instead of the options if liquidity in the options market is poor. Don’t think that if a stock is actively traded, the same will always be the case with the options. Some stock options are just too hard to try to trade. Focus on stock options that have competitive bid/ask spreads, large volume, and open interest. If you’re able to execute properly, you could save some money and prevent damage to your options account.
Leverage is a double-edged sword. It can turbo-charge your returns, but if you abuse it, it can destroy your trading account. This is especially true if you get in the habit of selling call options naked, which is a big options trading mistake that takes out many confident traders. Premium sellers advertise their strategy as a form of collecting income. But that expression downplays the risk.
There is nothing wrong with selling premiums, but your position sizing needs to be small enough to be able to absorb the worst-case scenario.
In poker, a hand that has a 98% chance of winning can sometimes lose out on the river. In trading, your risk goals should be to live to fight another day. If you put yourself in a position that can potentially blow out your account if you’re wrong, then it will happen if you expose yourself enough times. This is the options trading mistake that will take you out of the game, whether you’re ready to leave or not.
With options, you can improve your odds of success while using less capital. Also, they offer you a hedge to reduce your risk. Not to mention the versatility they offer. However, there is a learning curve with options. Don’t think you can jump right in and start crushing it. Know the inherent risks in the trading decisions you’re thinking of making, so you can avoid these four common options trading mistakes and stay on top of your game.