Options trading can be extremely lucrative. However, there is a learning curve you must go through first. That said, many traders who try options fail. But it doesn’t have to be that way for you. Furthermore, I want to share with you some tips that have helped me become a bonafide options millionaire, and share with you four of the most common problems that I see options traders face.
#1 Options Trading Problem – Unreasonable Expectations
Now, good trading for me might look like this:
That said, people who join my service may see these type of returns and think they can do it too, right away. But here’s the thing. It took me nearly a decade to reach this level of options mastery. Sure, I can help you cut the learning curve in half, but you still need to learn the basics. Options are a completely different asset class than stocks, they move differently, and they trade differently.
If you don’t know how puts and calls work, then you should paper trade first. After all, options are a derivative of stock, which is just a fancy way of saying the price of the option is partially derived from the movements of the stock price. However, other vital components include volatility and time.
Solution – Education
Be eager to learn first. Make money second. Don’t short yourself on knowledge. I only trade a handful of strategies, most of them very simple. However, that doesn’t mean I don’t know the core concepts or advanced strategies. Most option positions move fast. In other words, trial and error using real money can be very costly.
What should you know after establishing a strong foundation?
A basic understaning or knowledge of:
- The mechanics of puts and calls (risk and profit potential)
- How time and volatility influence the price of an option
- How to distinguish if options are rich or cheap
- The different types of option trading strategies
If you feel you’re inadequate in any of these areas, that’s okay. Here’s a copy of my latest eBook, 30 Days to Options Trading.
#2 Options Trading Problem – Trying to trade options like stock
The beauty of options is that it allows you to risk a small amount of capital and potentially turn into large sums of money. For example, here is a recent case, and earnings winner I had in XPO Logistics (NYSE: XPO) options.
A $6,000 bet that turned into $31K. That said if you’re not aware of the role that time and volatility have in options then it’s possible to lose money buying a call even if the stock goes up. Of course, this can be very frustrating. However, think about how much of an advantage you’ll have when you learn this stuff. You see, with options you can do a lot of things.
For example, with stock, you can make money by being long or short.
But with options, you can make bets on where you think a stock won’t go.
In fact, you can make non-directional bets that solely focus on volatility if you wanted to.
But for now, here are some basics you should know about options
- the higher the implied volatility is, the more expensive options are
- the more time to expiration, the more costly options are
- at-the-money options are the most sensitive to movements in the underlying price (their price will change the most)
- option traders use volatility to measure if an option is rich or expensive not by its premium
- implied volatility is the market’s best guess on how volatile stock will be in the future
- never sell naked call options on small-cap stocks, the risk is just too high
- Options are wasting assets. They either will expire worthless or in-the-money
- time premium goes to zero at the expiration date
That said, the strike price you select, implied volatility, and time to expiration all matter. Knowing how all these factors work will help you choose the right options and strategy.
#3 Options Trading Problem – No Edge or Trading Plan
Now, you can make money trading options by betting on stocks going higher or lower. But you can also make volatility bets with options.
For example, here is a recent option winner in Apple. It’s a bet that Apple won’t move as much as the market anticipates, a short volatility trade.
However, I didn’t randomly put the trade on. I figured the stock wasn’t going to move much because it already had earnings. Also, there weren’t many economic catalysts that seemed too concerning. You see, when you short volatility, you want to make sure that you’re collecting enough premium to justify the risk.
“The war is won before it’s begun.”- Sun Tzu
We all have different comfort levels when it comes to risk. Options can move fast, but they can also run slow (if you apply the right strategy). That said, it’s a good idea to take a self-assessment… ask yourself questions like:
- How much time do I have to trade and do research?
- What is my risk tolerance?
- How do you feel about losing? Do you want to win more than you lose or do you not care, just as long as your profits exceed your losses? Believe it or not, for some traders, being right is essential for their ego. As for me, I leave my ego at the door when I trade.
- Do you understand the strategy you want to place?
- Do you have a profit target, an adjustment strategy, and exit in case you are wrong on your idea?
- Do you have a good reason to be in this trade?
Why should you be so thorough?
Because there’s money on the line.
#4 Options Trading Problem- Poor Risk Management
Option premiums can move fast as they approach expiration. If you’re coming from the world of stocks, and you’re used to getting in and out of trades fast, then you’ll have to adjust. You see, with options some spreads are wide. That is, the difference between the bid price and the asking price is wide. It makes execution difficult. In other words, you can get chopped up getting in and out of some options trades.
Some people buy or sell too many contracts with the belief that they’ll be able to stop out like they would as if they’re trading stock. When a stock is volatile, the underlying option spreads may get so wide that it makes it almost impossible to get out without taking a big loss. It’s better to size your position small and let the leverage work for you.
Over-leverage is a fast way to bankrupt an options account. When you’re trading too big for your account ask yourself what the consequences are if you are dead wrong. A lot of times, traders will lie to themselves by defending their actions by using fuzzy statistics.
If you’re not familiar with how probabilities work and how outliers impact markets, make sure to read Black Swan Event Explained – How To Profit From Outliers.
Another reason why you want to trade small at first is that you’re still learning. Experience has made me a better trader. However, I was able to get to this stage by making small mistakes while I was learning. If you let one trade ruin your account, you will rob yourself of much-needed experience.
Educate yourself and don’t be too proud to trade on a simulated account. If you need to have skin in the game to be interested, then trade very small.
As you’re learning, try to put yourself in a position where you don’t have to suffer significant losses. Avoid strategies that you don’t understand or and anything else that is too risky for your tolerance.
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