As an investor, you may know that trading in options can help you make considerable money when the stock goes down or up. You will be happy to know that options trading can be an excellent way to manage your risk and take advantage of high probability trading with relatively less required capital. Learn why trading options is better than trading stocks. However, note that options traders of every level usually make the same mistakes repeatedly.
You have to avoid these options trading mistakes, particularly when making and managing complex, risky, and speculative trades.
Lack of a Trading Goal and Exit Plan
When you enter into an options trade, it is vital to have a clear goal and exit plan in mind. This is regardless of whether it is a complex or simple trade. For example, when doing something as simple as selling a covered call against a specific stock position you own, note that your goal can be something like "the call option will expire worthless, and I will keep the premium."
You should also have an exit plan or strategy, even when things are going in your favor. This means that you should choose a downside exit point, an upside exit point, and a time frame for each exit in advance. For example, with the covered call, if the trade works out favorably, your exit plan can be to wait until expiration and write another covered call, or to simply close out the entire position after a specific profit target is met.
Not having an Options Trading Plan
It is important to know your trading goals, allowable risk, and expected profit. You should also know and understand what will need to happen in order to make you cut your trade short before an insignificant loss turns into a huge loss.
This means that you'll need to know how to roll and manage your options positions, something David Jaffee teaches in his options trading education course.
Choosing the Wrong Expiration Date
It is usually difficult and tricky for novice traders to choose the right expiration date. This is why they end up picking the wrong one. When choosing the right expiration date, you have to consider specific parameters as an options trader.
These are some of the factors that traders must consider when choosing the expiration date:
- Liquidity in the underlying stock or assets
- How long do you think it will take for the trade to play out
- Perhaps most importantly, as an options seller, you need to take volatility into account. You can create “synthetic increased volatility”, and collect more premium, by choose an expiration that's 2 – 3 months out, however if volatility, as measured by the VIX, is very low, then a longer-dated expiration will be much more sensitive to changes in volatility than a shorter-dated expiration.
- However, if you choose a shorter-dated expiration, then you may not receive enough premium to make the trade worthwhile.
- This is one of the reasons why trading during periods of low volatility is so difficult.
Ignoring the Probabilities and Odds
The market won’t always perform according to the expectations and trends displayed by the history of the underlying asset or stock. You should take into account the probabilities and odds for your strategy when placing a trade.
Odds merely describe the likelihood that an event will or will not occur. This is because it will put into perspective what will likely happen statistically.
As option sellers, we like to sell premium because the actual move is usually always less than the expected move.
However, you need to ensure that you do not trade too large because your win rate has to be high when selling options to compensate for the occasional losing trade.
Not Understanding Volatility
You may know that options traders use implied volatility to gauge or assess whether an option is cheap or expensive. Note that the future volatility is usually shown by using data points. You should know that high implied volatility often signifies a lot of fear.
Thankfully, as option sellers, you're compensated more for selling options during periods of heightened volatility.
Both experienced and novice options traders can sometimes make costly mistakes when trading options. Trading options can be an excellent strategy for limiting risk, diversifying your portfolio, and generating profit — when you execute it well without mistakes.
Do not put too much money into any single trade, refrain from making speculative bets and have a clear plan of action and exit strategy when entering into a trade.
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