Top 10 Mistakes You Should Avoid in Option Trading
If you are a keen investor, you most probably have heard of bonds, stocks, ETFs or mutual funds. Options are also an asset class that if traded correctly have advantages that are not common to stocks trading or ETFs. Options just like other asset classes can be purchased through a brokerage account.
Options make for an outstanding investment vehicle because they increase income protection and they have leverage. They can, for example, be used as a hedge that limits losses in a declining stock trade. They can also be used to speculate on a stock’s direction or to bring in recurring income. Options generally have more options for trading but have just as many risks as other traded asset classes.
Options fall under securities known as derivatives, an asset class considered very risky and volatile. Warren Buffet has described these volatile assets as “weapons of mass destruction.” Derivatives derive their price from other objects and options derive their prices from various financial securities.
Knowing how to trade in options appropriately can give you an advantage in their markets. Trading them without a good strategy, on the other hand, can cause catastrophic losses. For example, every options trader has a finite timeline with which he or she can trade to make profits on transactions. Once that bus passes, losses begin to accrue.
Trading in options is not gambling. Below are some mistakes that an options trader should avoid staying afloat in the options market.
1. Purchasing out of the money options
Out of the money or OTM options are usually cheaper than other options and are very popular with traders. The thing about options pricing or any asset pricing for that matter is that there’s nothing like a free lunch.
The value of a purchased option will decline with time so the price of the OTM call options should move above or below your selling price before the expiration period of the option. If this happens favorably, you will then be in a position to offset your option’s purchase costs.
While trading in OTM call options can make some profits, it is also not easy to make consistent profits off of them. If you are limited to OTM options only, you will end up losing some of your trades consistently especially if you do not keep the volatility of the asset in mind.
2. Misuse of leverage
When trading in stocks, share purchase is made at the full price of the shares. Options are derivatives, so they are much more affordable than most stocks. Options will enable you to purchase stocks for a fraction of their real costs.
This may cause most traders to put in more money in one options trade than they should thanks to overleveraging of trades. An options trader has to learn to master leverage. Ensure that your losses are limited to between 1% and 5% of your total trading portfolio. If a trade goes south, this ensures that you will not lose too much and can pick yourself and try an alternative deal.
3. Not having an exit plan
A good investment trader has to be very level headed when trading. When dealing with options a handle over emotions can help you stay safe by making a plan and sticking to it. A good plan will have an exit plan that should be taken even when things are seemingly going your way.
There should be exit points for the upside and downside trade and all timeframes for exits should be observed. The point here is to make more profit consistently and fewer losses to keep you profitable. You will of course get tempted to ignore a trade’s exit point, but this is when you will require self control the most.
4. Avoid new trading strategies
Keep your ear on the ground and do not get used to only one trading method. The prices of options move differently from those of their underlying stock. Be flexible and diversify your methods of trade to ensure that you can apply a different trading condition for various assets as per their tendencies.
5. Trading in assets that have little volatility
A liquid asset enables traders to buy it and sell it off fast, and markets with such assets have active and ready players. Stocks trading are of a more liquid nature that options. This is because stock assets are not as diverse as options assets. Illiquid options accrue high costs of trading, so pick liquid options.
6. Staying oblivious to events in the market
Some traders buy options when the market condition is quiet and make some profits as the trade remains docile. If you do not check to see if there are any movements due during the trade’s time frame like an earnings release the market conditions could suddenly change and increase the asset’s volatility. It is essential therefore to monitor the options economic calendar and create a plan for trading around them.
7. Chasing waterfalls
While making huge gains can be exhilarating, it is the smaller consistent gains that will keep you growing. Home runs are not easy to spot during real-time trading. Making small regular wins, on the other hand, will build your capital. Losing a home run trade could cost diminish your capital gains making it hard to recoup losses.
8. Choosing the wrong size of a trade
Let your choice of trade sizes match your trading prowess. Do not risk your portfolio by taking on too much risk. Take time and practice and figure out what is the best trading size for your portfolio.
9. Not investing in yourself
Learn more about options trading, and it will pay off by assisting you in creating better trading opportunities.
Tip: Buy your options with cash so that you can stay debt free or taking any loans up to $5000 from online lenders. If you trade with money, you are only at the risk of losing the amount of capital you have invested in the trade. Ensure that the money is yours and not credit especially if you are a new trader. Borrowed money has interest charges that will eat into most of your profits or compound your losses. If you consistently open long position trades, you will also not have to worry about being in debt.
10. Not having a mentor/ coach
Have a trading partner who keeps you accountable to your plan will keep you on the right side of the trading track. An accountability partner can be a friend, sibling or spouse who will check in your progress and keep you in check.
The final word
Trading in options is an excellent way to wealth but only if played by the rules of the market. If well implemented these financial assets can diversify your trading portfolio. New traders in options trading should start with paper trading first.
Paper trading will give you a hands-on feel of what is expected during options trading. Every trader will at one time or the other make some trading mistakes. If you do that, adapt and try again. Better still, avoid making the mistakes outlined above, and you will find it easier to find your trading groove and the profit that you desire.
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