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Option Trading Mistakes
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Life is all about options – some follow this rule even in their trading regime. Though Options can help win big on the stock market, however, things can easily go spiraling downwards. So, we’re here to discuss the most common option trading mistakes that traders commit unknowingly.
Options trading has long been the go-to method for traders who like to stay clear of the risky stretch of the trading journey.
The traders are provided with a safe door to escape out of any contracts as soon they get the slightest sense of a loss.
Options are a type of derivatives contract where traders purchase or sell financial security at a certain price on a certain date.
However, unlike Futures where traders simply have to go ahead with the transaction, options traders are free from any obligation of fulfilling that contract.
Retail investors prefer options trading because of the possibility of huge returns.
However, there is the possibility of traders failing to enact their trading strategy effectively and often commit certain option trading mistakes that can lead them towards losses.
Traders who trade-in options, although enjoy relief on the risk quotient, they have to pay a small portion of the actual price of the underlying asset called “premium” at the time of signing of the contract.
Thus, options traders have to take up a bit of a loss initially.
Without a doubt, Options trading is lucrative, but traders can often lose the plot and make silly mistakes. For avoiding the risk you can choose the best indicator for option trading that can help you to earn returns. For this, it becomes essential to choose the right app for option trading.
However, even with the right trading platform traders made some usual mistakes that are discussed below.
So, let’s discuss them one by one and learn how to reduce the chances of loss in the option trading.
Option Trading Mistakes To Avoid
Traders can be attracted by the huge money-making potential from this financial instrument, but the stats suggest that idea is far from reality.
Options traders either make huge money with the rise in underlying asset’s value, or they lose big time.
The two parties involved in the trade – buyer, and seller, can opt-out of the contract at any moment. However, as a safeguard, the seller receives some amount of token money called premium from the buyer.
The seemingly easy appearing transactions can be troublesome in reality, and many new traders get confused and commit option trading mistakes.
So, if you want to trade-in options, make sure you avoid these common option trading mistakes to avoid.
1. Trading Without Knowledge
The first and probably the biggest of all option trading mistakes that a trader can commit is trying his luck in options without actually having a proper understanding of how things operate, how to strategize to meet trading goals and objectives.
Options as talked above, are a type of derivative that derives its value from the underlying asset. Now, options by their nature are complex, and they can confuse even the most experienced and knowledgeable trader.
So, getting into something which is considered a tough nut to crack without being informed of the concepts, aspects, and risks involved in the last thing you would want to do.
The market is full of stories of novice traders getting into options trading full of optimism only to return with empty pockets.
Here’s the classic example – Trader makes a call option on a stock valued at Rs 100. Instead of going up, the stock loses its value and shrinks to Rs 90. Now the trader won’t want to exercise his call option.
But the trader will remain at a loss, even if he doesn’t purchase the stock because of the premium he paid to the seller.
Cases of traders losing money owing to their lack of knowledge are common occurrences in the stock market every day.
We don’t mean to say that a trader will need to be aware of each and every concept of options, but a trader should at least be aware of the basic concepts of call options, put options, premium, strike price, the various options strategies, etc.
Remember, knowledge is your only savior.
2. Trading Without A Plan
Being new to the world of trading, many often commit the mistake of trading without a plan. They simply take up a position on stocks without deciding when to exit.
There are various factors that need to be brought into consideration while options trading.
Now planning your trades isn’t as tough a task as many might think. The trading plan should contain – an entry point, exit point, your profit target price, the maximum loss you can take, the strategy you are going to employ, the maximum adjustments to your position.
The best a trader can do is to define the exit points. The trader can be buying or selling options. However, without defining the exit points traders will never be able to exit the positions at the right time.
There can be times when the trader feels that because the stock has gone up a notch or two in value, he should wait and hold his position for some more time. Instead of the prices going up, the stock prices declined.
So, traders should set a target and when they get anywhere closer to the value, exit those positions immediately.
3. Not Trying New Strategies
The chances are that traders employed the basic long call, long put, short call, short put strategies while trying out options trading for the first time. However, options trading doesn’t at all have to be about orthodox strategies.
In fact, traders with basic knowledge will start with the most basic strategies. However, once the trader has gained some decent experience, they should look to switch things up to earn more profits and protect themselves from incurring huge losses.
Make sure you do not end up using regular intraday trading strategies in the case of this format. There is a huge difference in terms of capital, risk level, return levels in these two formats of Option Trading Vs Stock Trading.
Traders who are making a decent amount of profits would be apprehensive of trying out anything new and would be afraid of running the risk of traveling in unfamiliar territory.
However, that is another one of the option trading mistakes that traders make owing to their lack of knowledge. Now, there are a wealth of options trading strategies as per the stock market circumstances thus the trader can actually opt according to toe their needs and requirements.
Traders should always be eager to learn. There’s a strategy for literally every move of the market, be it uptrend, downtrend, sidewards movement, or no movement at all. Focus on the underlying value of the stock, that’s it.
Choose from the vast range of options trading strategies that include the likes of – Long Straddle, Long Strangle, Collar, Protective Call, etc.
4. Trading In Illiquid Stocks
Liquidity defines the ease with which a stock can be traded. Higher liquidity tells that a stock can be traded readily in the first instance.
However, traders, especially the fresh ones, commit one of the most common option trading mistakes of picking illiquid stocks.
Trading in illiquid stocks is probably the easiest of all the option trading mistakes that a trader can make because identifying a liquid stock can be difficult for a trader that lacks the requisite knowledge.
When trading options, you can have multiple expiration dates, at least 3 and sometimes even more than that, which means that options trading by its nature isn’t liquid.
It isn’t uncommon to hear traders moan about failing to sell the stock.
So, traders should look to be more watchful in terms of the stock he/she chooses. Traders should look to trade in stocks of large-cap companies, medium companies.
Generally, the stocks of these giant names enjoy a fair share of ease.
For Example – Stocks listed by Tata Motors are more liquid and can be traded readily in the stock market.
This is because of the brand equity and huge trust that traders and investors have in the well-established brand that TATA is.
Whereas stocks listed by a relatively lesser-known company or a new brand in the market would be comparatively less liquid.
Hence, traders should ideally look for stocks of big companies that have a strong foothold and a good reputation in the market among investors and traders.
The only problem with purchasing these stocks is that they are more expensive too.
Trading stocks of upcoming brands can be more rewarding than stocks of blue-chip companies, large-cap companies. However, the risks involved will be just as high. So, it is a trader’s choice to make.
With bigger rewards comes risk just as big, as simple as that.
5. Ignoring Short Options
Next up on the list of the most common option trading mistakes is traders turning a blind eye to short options because these are highly risky and profits are low.
However, with the right trick and knowledge, these can prove to be great saviors during a downtrend or a steep fall in the stock market.
Now a short options strategy means that the trader sells the underlying security for a certain price, only to buy it back in time before the option expires.
The trader purchases the security for a price much less than he initially sold it for and thus makes reasonable profits.
However, things look much easier on paper than they are in reality. The trader is running the risk of timing the trade right.
The trader should look to book his profits, and in case he sees the options go OTM (Out of The Money), the trader should buy back the stock immediately.
Also Read: What happens when the option expires out of the money? and Option Trading Charges
When trading in options, traders cannot afford to take some time to make their move. Options traders need to be on their toes at all times and look for opportunities to make money wherever possible.
Traders often wait too long to reclaim their short options. That’s another of those option trading mistakes. There are a couple of reasons for that too:
- The trader will have to pay a commission
- The trader can get greedy and keep on hoping that they can make some extra profit by holding the contract for some more time.
But, don’t wait too long when you’re shorting your options. Book your profits before it gets too late.
Remember, shorting options is about timing your orders right. You need time for the underlying asset to make some movements, and you want to keep some time for yourself so to buy it back before the contract expires.
6. Over Leveraging
Margin or Leverage facility sounds pretty interesting to new traders who come with an optimistic outlook and make movements towards the idea of maximizing their profits by using this facility.
Margins no doubt can ensure big profits. However, you are running the same amount of risk too. Being optimistic is one thing but blatantly refusing to give a thought to the possibility of loss is straight foolish.
That’s another of those common mistakes in options trading, that fresh traders are guilty of committing.
Since options are comparatively cheaper than trading in stocks, traders get excited and purchase more shares, and look to maximize the profits by opting for the margin facility.
However, options don’t work the same as it works with stocks.
So, traders, when trying out options for the first time, should start small. If the trader can work their magic in fewer contracts, only then should he entertain the thought of increasing the number of contracts.
The same rule should apply when you look to learn a new strategy, begin small, and gradually work your way up.
This way, you not only can limit the risk but also gain some experience to better understand how things work in the stock market and learn about the volatility of the strategy and asset.
7. OTM Options
Although people vary of a thing’s quality that comes cheap in life, however, options traders for some reason or the other don’t follow the concept and end up incurring losses. How?
OTM Options!
OTM options or Out Of The Money options make for attractive bait for quite a number of new options traders. These are comparatively cheaper than ITM options (In The Money) and ATM options (At The Money) because the underlying asset is far from the strike price.
Now, because the OTM options don’t have an intrinsic value, which is the difference between the underlying stock’s current price and the option’s strike price.
Thus the premium to be paid will be less than any stock that has an intrinsic value.
Most of the time, these options end up worth nothing. However, these provide a great opportunity to win big as well, traders can certainly make use of the margin facility and maximize their profits.
Here the trader should play cautiously and a little negligence can actually lead to face the biggest option trading mistakes.
However, sticking to the buy cheap and sell high mentality can be hard to replicate in reality every time. So, a trader should adopt a Covered Call strategy, which can help you earn profits despite you being in a bullish position.
So, if a trader has trust that the stock will soon gain its value, he should buy an OTM option with an expiry date that can prove to be a decent time frame for the stock price to make a reversal.
The trader can thus earn by selling it for a price higher than the initial purchase price. That is why to earn profits and avoid risks, you must be aware of when to sell call option?
As discussed in the fifth point above, OTM options can be utilized for generating some amount of money from lost cases, as in short options. However, this requires a trader to be capable enough of enacting short options strategies effectively.
Knowledge is Power.
Conclusion
Options are downright one of the most popular financial instruments for traders who like to be on the safe side of things. In order to avoid the mentioned mistakes it is important to understand option trading basics.
Also, it is recommended for the traders to start small and understand the market behavior before getting into the trade.
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