Are you a stock trader looking to start investing? Options trading is a great place to start since you don’t need a large cash outlay. However, without the right trading strategy, you might lose more than you invested in a short period.
Therefore, you must refine your style and strategy to start options trading. Moreso, you must be aware of the common mistakes options traders make and how to avoid them so that you can steer clear of losses while getting started in the markets.
Mistakes Options Traders Make And How To Avoid Them
Options trading is ideal for individuals looking to start investing as it doesn’t require large capital injection. Besides, there are many resources on the web, and the most famous person to teach you is Chuck Hughes, as he has many materials published and has been a long-standing winner of the World Trading Championship. You can follow his Instagram account to get regular update. However, before you start options trading, familiarize yourself with the following options trading mistakes and ways to avoid them for successful trades.
Absence of a Trading Strategy
One of the most common blunders new traders make when dealing with options is not having a trading strategy before making trades. Charting out strategies without any risk management system will often leave you wandering through different trades without knowing where they lead, as you mostly rely on luck. This usually ends up disastrously because there is a high probability of making the wrong trades.
You must learn all the options trading fundamentals to avoid losing all your money. It would be best to grasp how an asset’s volatility, probability, and price movements affect the options’ prices. This will better allow you to map your goals before diving into any trade. You can also put together specific entry and exit points while establishing the stop losses limit. This helps you ensure a greater short-term and long-term success rate.
Choosing the Wrong Position Size
Another mistake traders make is not correctly sizing their positions. This means having too small or large of a position relative to what they are comfortable with and can handle regarding potential losses. And this is mainly driven by fear or greed.
You can avoid this by calculating how much capital should go into each trade so that no matter what happens during market fluctuations, there won’t be any unnecessary surprises floating around afterward.
The best way to choose the right position size is to risk a certain percentage of your account value; it could be 1% or 2%. And use a consistent dollar value, such as $100.
Overall, ensure you are comfortable with the amount you inject, whether you lose or win. The capital should be large enough to be significant but also small enough so you don’t have sleepless nights.
Choosing the Wrong Expiration
Options have expiration dates, meaning you must select an expiration date before trading. However, many new option traders overlook this important step and make bad decisions because they’re unaware of how quickly time flies by while trading.
It’s easy for beginners since different types of contracts come with varying amounts until expiration, but regardless don’t forget about these deadlines, as they will ultimately determine whether or not profits are made from particular investments.
You can use a checklist to determine your expiration.
- Ask yourself how long it will take the trade to play out
- Do you want to hold the trade through a stock split or other events?
- Do you have sufficient liquidity to support your trade?
Options traders should always consider the underlying security’s implied volatility (IV). This metric measures how much risk is being priced into the stock and provides valuable insights on whether it may be undervalued or overpriced compared to its historical trends.
By staying up to date with IVs, you’ll determine which contracts are likely best suited for your trading style. Too high values usually mean more risky trades, whereas lower levels signal safer options.
Failing to Diversify
It may sound cliché, but diversifying portfolios by investing in multiple assets is essential to trading success. This helps reduce risk significantly since not just relying solely upon single type security, especially with options contracts.
When trading options, you have better chances than buying promising stocks. This is because many strategies and tactics exist when trading options, such as covered calls, bear put spreads, and married puts. Therefore, you must always apply multiple trading strategies to even out the other unsuccessful ones.
Lack of Discipline
Traders must maintain strict discipline and self-control while engaging in option trades. Irrespective of how good your strategy is, a lack of control over emotions can quickly turn profitable situations into failures due to rash decisions or moments of hesitation.
If you want to avoid such scenarios, establish rules and target goals and strictly abide by them throughout the process.
Buying Options Using Margins
Using margin when buying options carries extra risk compared to cash transactions. Many inexperienced traders think they’re getting “extra” leverage by using debt instead of capitalizing on stronger returns from underlying securities directly themselves.
Unfortunately, this isn’t necessarily a fact; a margin amplifies your losses since you have more money tied up in trade than you would without it. And any small price change can result in huge swings in either direction.
When trading, always use the money you can afford to lose; in this case, margins will only leave you deep in debt. So as a beginner, margins are best left to advanced traders.
Focusing on Illiquid Options
When trading with stocks, converting them into cash is easy, as they can be sold as soon as the market opens. However, options are different because you can’t sell them for cash as you wish.
As an options trader, you are at the behest of the bid-ask spread. This means that the price at which you list your options is different from what the buyers are willing to pay or bid. As such, you might have problems finding a buyer when you urgently need the cash, which is made worse by the rapid price fluctuations with options.
Failing to Understand Technical Indicators
Technical indicators can provide invaluable insights into market conditions. However, many traders don’t bother taking advantage of these tools, leaving themselves exposed to larger risks than those who invest in studying these analyses properly.
Therefore when trading options, familiarize yourself with technical indicators, such as delta, gamma, vega, and theta. For instance, the delta tells you an option’s price sensitivity, while theta explores the effect of time. Therefore, you must understand these indicators well to read the chats and understand the various indicators.
Failing to Use Probability
When trading options, it’s essential to consider each trade’s success probability. Unfortunately, many inexperienced traders will enter into positions without proper research. This means they’ll take on unnecessary risks while gambling with their capital rather than calculating odds based on probabilities, such as analyzing past data or examining technical indicators like Bollinger Bands.
You can avoid this common pitfall by running through simulations before actually engaging in actual trades; this way can get a better idea of what kind of returns to expect from particular setups, thus significantly bringing down the overall risk factor.
Focusing on the Expiration Graph
Another mistake novice options traders make is focusing solely on expiration graphs when selecting contracts. Although these visuals provide helpful visual aids regarding pricing and volumes, they don’t tell you how much you carry today or in the future.
The best way to see how your position will react to the price movement is to use the profit/loss calculator.
Not Having an Exit Plan
Before entering into any trade, it’s crucial to have a well-defined exit plan in place. If the market goes against your expectations, you won’t be left helplessly watching as your hard work, and investments go down the drain.
You can ensure this doesn’t happen by writing out possible outcomes, such as setting stop losses or having predetermined conditions when you should cut losses and take profits.
Not Factoring in Upcoming Events
The market is always changing, so traders must constantly factor things like news announcements and earnings reports into their strategies. Failing to do so could lead to unpleasant surprises.
For instance, if a company unexpectedly releases bad quarterly results, stocks could plummet quickly due to panic selling investor sentiment. The same holds for positive developments, too, where prices soar past initial estimates creating potential windfall profits for everyone involved.
Therefore, pay attention to upcoming news and events to make informed decisions about an options contract’s current and future price movements.
Insufficient Time Awareness
New traders often underestimate how essential time frames can be when trading options. While trading options, you realize how valuable time is as your premiums may be pushed down while attempting to chase a move, whereby you end up overlooking the value-related drop (time decay). And this results in lower profits.
The best way to take time decay is to trade in time-bound options, meaning you exit as soon as the time set elapses
Traders must understand common option trading mistakes, what they are, and how to avoid them. Although there is no one-size-fits-all approach, by keeping in mind some of the most common pitfalls we’ve discussed here, such as lack of strategy or knowledge about volatility and probability, choosing the wrong position size or expiration date, you will be better equipped to steer clear from losses while getting started investing.