6 Mistakes Newer Option Traders Make
Trading options is more intricate than just trading stocks. The timing element of options makes it a great way to create a strategy based on what your views are with the underlying stock or implied volatility. It takes time to develop a strategy and use options for more than just purely buying a call but it’s well worth understanding the risks and rewards of different strategies for different markets. When used correctly, options are easily the best way to gain control in the market no matter if you’re bullish, bearish or neutral. But it’s important to avoid the most common mistakes that newer traders make.
Mistake 1: Buying out-of-the-money (OTM) options as your only strategy.
Cheaper priced options might sound like the lower risk trade but they are priced that way off a probability model and are cheap for a reason. The same way that a bad football team might be offering a 100 to 1 payout to win the Super Bowl at a sportsbook. They have a 1% chance to win for a reason and it’s not often mispriced. Sure you may be able to buy a few 20 delta calls now and then and win if they go in-the-money but if you don’t get a faster move you will learn that theta decay eats away at the price.Velocity of the move matters when buying options. Buying OTM calls outright is one of the lowest odds ways to make consistent money trading, and consistency should be the goal. If this is all you do, it’s nearly impossible to win in the long run and thus you will get discouraged and not continue learning further strategies that have higher potential.
It’s hard enough picking a direction in a stock but then needing to be right on timing before a certain date to just break even at your strike price makes it extremely hard as a newer options trader. Each day that passes and the stock stays flat costs you money and is like a pool of ice melting in the hot sun as time value erodes. This is magnified with short dated options like weekly’s that decay very fast if moves don’t happen as expected. OTM options are cheaper because the lower delta of the option translates to the probability of that stock closing above that level at expiration. A delta of 20 means the options market is pricing in a roughly 20% chance the stock closes above that strike price. A probability of a touch is about double that which still is just 40% odds. Not the best probability of consistent gains. If you are going to buy an option then at least going out further in time and buying an at-the-money or slightly in the money delta of 55 gives you a 55% chance at success.
Instead of buying an OTM call, try to trade a covered call and see how the premium of that OTM changes with each day that passes. Buying 100 shares of stock and selling a 30 delta call or just selling an OTM call on stock you may already own is a “covered call.” If the stock rallies to and closes above that strike price you sold, you get “called away” from the stock and keep the premium you collected. You can also choose to roll out the covered call to a further out month and strike if the stock starts to rally and you don’t want to be called away by selling your shares. Generally you will be able to collect the credit and have the OTM call expire worthless or buy it back much lower as time decay does its work.
Mistake 2: Using the same strategy in all market conditions
Options are all about being flexible in your strategies and having the ability to mix up the type of strategies you use based on how the markets are acting. By learning several different option strategies you’ll be able to effectively navigate an up, down or sideways market. Whether volatility is high or low there’s an option spread strategy to take advantage of it. Trading spreads is one of my favorite ways to profit in different markets and it’s an excellent way to explore how to control risk while still making a directional trade.
Buying a spread is called a “debit spread” as you are paying a debit to own it. Selling a spread is called a “credit spread” as you are collecting a credit for selling the spread. These are also called Verticals. Many newer traders get convinced that simply buying calls is the best way to make money because of the “homerun potential” but very few traders actually make money from just buying options all the time. There are times when buying a call is warranted based on how low premiums are or other factors but as a newer trader you will learn more from using spreads as your timing develops further. Buying a long debit spread limits your potential profit but it also limits your loss to the max risk of the debit paid and it tends to cancel out theta decay since you are short an OTM option against your long option.
Selling a credit spread offers up a higher probability of success because timing is less important and the stock can go sideways and you still profit if you sold an OTM spread. In highly volatile markets this is a better strategy to play direction because implied volatility is higher and you are selling a spread which takes advantage of a potential IV crush while also having a directional bias. Butterfly’s, calendar spreads and iron condors also are other strategies to familiarize yourself with as they offer an edge in different market environments and tend to be more forgiving if the move doesn’t play out right away.
Mistake 3: Having no defined exit plan prior to expiration
Having a trading plan is important when trading options and knowing when to exit a trade is a way to control your emotions once you are already in a trade. Not just for minimizing risk on the downside when the trade goes bad but it’s also crucial to have a plan to exit winners. Whether you are using a trend following approach or more contrarian reversal strategies, it’s important to plan your exit criteria in advance. Everyone is always worried about taking profit too soon but if you can find a system that is repeatable and you continuously hit singles and doubles while reducing the magnitude of losses then you become a more confident trader in the long run. Trading with a plan allows you to become more consistent and build better habits that reduce worry.
Whether you are buying or selling options or a combo of both an exit plan is crucial. Maybe you sell credit spreads and take 50% wins when they come or maybe you buy long call spreads and use technical signals on the chart to determine your buy or sell price levels. Stick to your price levels, if they are violated then exit. There will always be new trades as long as the markets are around and open. Sitting in a losing trade sucks away your emotional capital in addition to your monetary capital. There have been many times when I stayed in a trade a few days too long trying to reduce the loss only to be so focused on that losing position that I missed out on 2 or 3 new trades that showed more promise. Always know the worst case scenario on each idea you trade and don’t let it be eclipsed. With profit targets, don’t become stagnant, if the market changes character then be willing to adjust your profit target a bit lower to book a profitable trade. Don’t get greedy based on prior set biases you had envisioned. Markets move and our assumptions should move with them.
Mistake 4: Waiting too long to buy back your short options
This topic kind of goes with the aspect of sticking to your plan and knowing your exits. When trading short options and being an option seller you have the wind at your back most of the time since time value decay is on your side. But waiting too long to buy back or cover the options you sold just opens up more risk the closer you get to expiration. Assuming a trade is profitable and you are trying to squeeze out the last 10-20% of possible credit you collected then you should just exit and look to reestablish a new trade in a new expiration. Now with commissions so low for options there is really no reason to not buy back short options early.
If you sold an option spread that is now far out of the money and still has time till expiration, just go ahead and reduce risk by buying back the short spread or naked option. Being greedy for that last few cents is rarely worth the risk and buying power it is using up. I usually like to buy back short options at between 50-80% of the max profit potential depending on how fast the profit came. For example if you sell an option credit spread for $2.00 and it’s now at $0.50 or less with several weeks until it expires then odds are it’s time to close the winner and move on. If you keep it on then you are trying to make the last 50 cents but risk it going back in-the-money since there is plenty of time till it expires still. The last 10-20% of an options premium maintains itself much longer because there is always that small risk of a multiple standard deviation move and those cheap 5-10 delta options stay above zero for that reason. A good rule of thumb is if you wouldn’t sell the option at $0.50 at this moment then you should probably just buy it back.
Mistake 5: Trading options with low liquidity
Liquidity is a basic requirement to trade effectively in the options market, especially if trading spreads. Being able to get a fair price and quick and easy fills depends on the stock and its underlying options activity. Trading illiquid options with wide bid-ask spreads is a sure recipe for frustration even if you are correct on what you see the stock doing. A liquid options chain is one with ready buyers and sellers at all times willing to transact. Having tight bid-ask spreads is important for being able to quickly move in and out of an option without causing large price moves. Most actively traded stocks have liquid options these days and there really should be no excuse for getting stuck in an option with poor liquidity. It’s never a good idea to open a trade in an option with a bid-ask spread that has a width of 10% of the option price. If you buy an option that is illiquid you are instantly down on the trade since the bid is so much lower than where your buy price likely was.
Stick to trading stocks that do at least 1 million shares of volume per day and the options market for that stock will usually be fine as long as open interest has several hundred contracts per strike. Stocks that trade over a million options contracts a day are among the most liquid stocks with options markets having the best opportunity. If you are newer to trading options, focus on these most liquid names that offer the tightest bid-ask spreads. Make sure there is at least enough open interest in the strike price to be able to trade. Some people like to say at least 10 times the amount of contracts you plan to trade should be in open interest. I just like to see overall liquidity in the option chain, this can be seen with volume and open interest up and down the option chain with narrow bid-ask spreads while markets are open.
Mistake 6: Breaking your pre-defined risk tolerance rules to make up for a past loss
Finally, going along with the thoughts on having a plan, it’s important to stay disciplined and follow the risk parameters and position sizing you have in your plan even after having a streak of losing trades. Often newer traders will “double up to catch up” on a trade that looks promising in order to make back losses on previous recent trades. Or even worse, doubling down on a loser in order to lower a breakeven. This is a recipe for disaster, as you likely should be trading smaller size during a losing streak anyway. But until your skill set and experience builds up it’s smart to trade with the same risk per trade. The only certainty with trading is that you will have losing trades. The key is position sizing so one loser or a string of losers doesn’t wipe you out. All seasoned options traders know compromising your risk tolerance to make up for past losses is an emotional reaction and you’re often tempted to react to emotions especially when things aren’t going smooth.
Simply trade the same way each trade looking for specific criteria to be met that you outlined in your plan and don’t “double down” on any trades. With options it can be a little different than stock. Since options are derivatives that means prices don’t move the same as underlying stock. Time decay and implied volatility will move option prices much more than you think and should be factored into your plan. If you are selling options it can be ok to add to the position if the trade goes against you initially and you aren’t at a full position size. But if the reason for why you entered the trade has changed, it’s often best to avoid adding to the trade. When things change in the markets, ask yourself if you would still take that trade you are in assuming you weren’t in it? If not then there’s no reason to double down just to catch up. You will dig yourself a deeper hole in a position that is telling you that it’s not working. Trim the hedges that aren’t contributing to your growing garden of profitable trades and be willing to move on to the next opportunity.