September 26, 2017

10 Options Trading Mistakes Every Beginner Makes

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The right options trades can be profitable. The wrong trades can be devastating. Read this to learn the most common mistakes and how to avoid them.

Mistake: Trading Without a Proper Plan

Trading options without a strategy is like driving a car without insurance. The potential for loss is tremendous.

You have a finite amount of time in which you can make money on the transaction. If you miss the opportunity, you may lose a significant amount of money.

If you don't make a plan before you buy or sell the option, your money-making goal might not pan out. Even the best-laid strategy can fail, but the odds are in your favor when you plan.

Before you make any trades, create a generic plan. You can then use this plan for most options, adapting for trades that require it.

A great way to test out your strategy is to conduct paper trades.

Some brokers, such as TD Ameritrade, offer this service. You get to do real-time trading, but without money. You put your plan in place and see how it pans out. You can then alter your strategy based on the outcome. It's not a guarantee that your plan will work when you get out in the real world. But some practice is better than none.

Mistake: Forgetting to Formulate an Exit Plan

Sometimes your plan doesn't pan out. Then what do you do? Without an exit plan, you keep the option. This could leave you with a significant loss. Even if you make a profit, you could lose it if you stay in the trade too long. Instead, you need an exit plan:

  • Choose your exit when you are profitable (how much profit will leave you satisfied)
  • Choose your exit when you suffer a loss (how much can you stand to lose)

Having a plan can help you sleep better at night. What if you leave money on the table by exiting too early? You'll move onto the next trade. Consistent wins are much better than even one significant loss. You aren't in it to hit the jackpot. It's about a consistent strategy that continually creates profits for you.

Mistake: Ignoring the Expiration Date

Among the many choices involved in options trading, the expiration date is a major factor. Once you predict which way a stock will go, you must decide how long it will take. Maybe you anticipate an earnings report to have a significant impact on the stock. Or you know of some other major event that should have an impact (hopefully in the right direction) on the stock.

These factors play a role. They'll help you choose the right expiration date. If you don't pay attention to the dates, you could trade an option that expires before the anticipated event. Then your entire trading plan could be worthless.

Mistake: Overleveraging Your Trades

If you gain experience in trading stocks before options, you are likely used to trading large sums of money. When you buy stocks outright, you pay the full share price.

Let's say you are used to buying stocks for $1,000 at a time. Now you switch over to options. Because options are a derivative, they don't cost nearly as much. You can buy 100 shares of stock for a mere fraction of what it costs for the underlying asset. In other words, you don't need to invest $1,000 and you shouldn't invest that much.

You could run the risk of overleveraging your trades. In other words, you might invest too much money in options.

A good rule of thumb is to limit your losses between 1 and 5% of your total portfolio per trade. This way, if a trade does go really wrong, you don't risk your entire portfolio. You can pick up the pieces and try a different trade.

Mistake: Buying Options Because They Are "Cheap"

Cheap isn't always good in options trading. The less expensive an option's premium, usually the more "out of the money" it is. While it might look like a "steal," it's unlikely to make you any money.

Options with lower premiums usually have a strike price well above or below the market price. In other words, you'll need a drastic change before you'll make money.

If you bought a call option, you'll need drastic upward movement. If you bought a put, you'll want drastic downward movement.

Unless there's a big earnings report or other announcement coming up soon, it's harder to make money on the deal.

This isn't to say "out of the money" options never work. It's just not the best strategy, especially for beginners.

Mistake: Not Knowing How to Handle Early Assigned Options

When you sell an option, you have an obligation, not a right. If the buyer assigns the contract, you must buy or sell accordingly. If you sell a call, you must sell the stock at the strike price. If you sell a put, you must buy the stock at the strike price.

There's no rhyme or reason why a trader would exercise an option early. Some investors panic and exercise their right because they don't know what else to do. Others are skilled and know when to cut their losses. Either way, as an option seller, you must be prepared for this situation. You'll need enough cash to cover the transaction or have possession of the underlying security.

Not planning for this issue could leave you high and dry.

Mistake: Choosing the Wrong Sized Trade

The size of your trade should match your portfolio. You shouldn't risk your entire portfolio, though. Going back to your plan, figure out how much you are willing to risk on any one trade. Then stick to that number. It could be a percentage or a flat dollar amount.

Always think in worst-case scenarios, though. Can you afford to risk x amount of dollars if you lose? If it will cause financial destruction, cut back.

On the flip side, though, you don't want to risk too little. While you might not lose anything, you could leave money on the table. It takes time and practice to figure out your comfort point. When you do, stick to it and readjust as you see the need to do so.

Mistake: Staying in a Written Option That Is a Loss

You don't have to ride an option out for its entire duration. If you know an option is going to expire "in the money," sell it to get out of it.

Writing options isn't like gambling. You shouldn't "hope" that the option expires worthless, leaving you with the premium. It could take a wrong turn overnight, leaving you with a significant loss.

In the case of a written put, if the stock price decreases, your option could cost you a lot of money. You are obligated to buy the stock at the strike price. You could lose a significant amount of money.

Rather than sitting on it, you can buy your way out. If the premium is only a fraction of what you sold it for, you still keep some of your premium. Consider it cutting your losses. You keep the premium, minus commissions paid. Now you aren't obligated to buy the stock at a price that would leave you with a loss.

A good rule of thumb: if buying your way out leaves you with at least 80% of your initial premium, do it. You walk away from the risk and still have some money in your pocket.

Mistake: Doubling Up to Make Up for Losses

Options can quickly turn on you. The panic that results could make you go against your best options trading strategies. Don't let your emotions take over, though.

Doubling up because you panicked could result in an even greater loss. Now you have even more at risk. If the stock continues to go in the opposite direction, you lose even more. Instead, cut your losses and reevaluate your trading strategy.

Mistake: Trading Illiquid Options

You want to trade options that have liquidity. In other words, you can trade in or out of them quickly. This helps when you are trying to cut your losses. If you have an illiquid option, you will have a harder time cutting those losses because the cost will be much higher to buy out of it.

When you trade options, pay close attention to the open interest. This signifies the number of open contracts for that strike price. The more open interest there is, the better. The same is true for volume. Just like with stocks, the more volume traded that day, the better. So again, you want a higher volume if you want a quick exit strategy.

Generally, smaller companies have more illiquid options and larger companies have more liquid options.

The Bottom Line

Mistakes happen. Don't beat yourself up if you've made one or more of them before. Instead, pick up the pieces and create a new strategy. If you are new to options, consider paper trading first. This way, you'll get a good feel of what to expect.

Even the experts make mistakes and lose money. It's the name of the game. As long as you adapt while you move along, you'll eventually get into a groove. Hopefully, that groove leaves you with the desired profits.

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