So you’re interested in getting into the world of options?
With the potential to make much larger gains than you would buying shares of the underlying stock, being able to potentially control over 100 shares of a company in a single options contract, and having that contract cost you a fraction of the price it would if you bought 100 shares of the underlying stock—I don’t blame you.
It’s easy to feel like you want a piece of this financial gemstone that titan-sized hedge fund managers rave about. But with rose-colored glasses, you might not realize that you’re making some common mistakes when you decide to enter into this dynamic, volatile trading environment. These mistakes could deter you from ever wanting to trade options again.
And the worst part? You might not even realize you’re making them.
Let’s go over some of the most common mistakes so that you can take advantage of the power of options without them taking advantage of you.
The Basics of Options Trading
If you’re new to the world of options, here’s some quick info to help get you started. If you’re familiar with the basics, feel free to jump to the next section.
Before we go any further, we need to briefly clarify the following terminology:
- Call Option
- Put Option
An option contract is an agreement between two parties involving the potential sale of an underlying security, at a specified price (called the ‘strike price’), prior to a specific date (the ‘expiration’).
Options have an intricate way of being valued. An option’s “premium” is the price that you buy a contract. The premium changes if the option is in-the-money or out-of-the-money.
So what does ‘in-the-money’ (ITM) and ‘out-of-the-money’ (OTM) mean?
A call option allows you to ‘call’ stock from another trader, giving you the right, but not the obligation, to buy stock at a set price over a set period of time. If the strike price of the call option is below the trading price of the underlying stock, you’re in business! It’s ITM. This means you can buy the stock for a lower price than its trading price. Pretty cool, right?
If it is a put option, you ‘put’ the shares on to another trader. They’re the inverse of a call option, giving you the right, but not the obligation, to sell stock at a set price over a set period of time. So an in-the-money put option would have a strike price above the current trading price, so that you can sell the stock for more than its trading price.
Another key factor in understanding options and their value is realizing they are a decaying asset. For every minute that passes, and the closer it gets to its expiration date, the contract will depreciate in value, like ice cream melting in the sun. Time value melts. This is because the closer a contract is to expiring, the less valuable it will be because there is less time for the stock’s price to move, meaning less time for your contract to move more in-the-money.
Think you got the hang of the basics? Let’s test your knowledge with a short quiz:
Let’s say you want to buy a call option for Johnson & Johnson (JNJ). The current stock price is $164.08, and the strike price of the call is $162.00. Is this contract ITM or OTM?
If you said ITM, you’re correct! Again, a call gives you the right to buy stock at a set price. So it would be advantageous to be able to buy it under its current trade price, as you’d essentially be getting it at a discount if you choose to exercise the contract.
Exercising a contract means you exercise your right to buy or sell 100 shares of the underlying stock of the call or put option.
Mistakes to Watch Out for When Trading Options
Now that you have a bit of background, let’s go over some common mistakes made when trading options. No matter your trading experience, these mistakes can happen to anyone – from first-time traders to experienced professionals.
Let’s jump into the following five key mistakes you want to avoid when trading options.
1. Not Sticking to a Plan
We’re emotional beings, it’s a part of being human. Unfortunately, it’s too easy to get your emotions tangled in a string of decisions when trading options. Just remember to remain aware of yourself and your emotions when you’re trading. An emotion like frustration can lead you to want to take a long shot, and you can end up digging yourself into a deeper hole than you were in to begin with.
Say you’re playing golf with your friend. You know that you can play well, but for some reason you’re playing terribly that day, and your friend is pulling further and further in the lead. As your frustration grows, so does your lack of awareness… you blindly decide to just try and hit the ball with brute force. You swing at the ball as if you’re chopping a stump of wood with a baseball bat, and the ball ends up going nowhere. You need to reach a state of contentment to find clarity – a zen state that allows you to make sound decisions.
Keeping your cool is one of the keys to success. Getting heated or angry can cloud your judgement—and at a time when news articles and experts are saying that the market is bullish and bearish at the same time, no trader can avoid feeling confused and frustrated. Keeping your cool helps you think clearly and stick to a plan without making rash decisions.
But if you simply make a plan, and stick to it, you can avoid the uncomfortable stress of huge losses, and make more consistent gains. A big mistake traders make is letting their emotions get the best of them, and they start breaking personal rules they’ve set for themselves and their strategy, like ignoring an exit price they set prior to the execution of a trade.
Here’s an example of what happens when you don’t make a plan and stick to it: you decide to buy a Tesla (TSLA) call option that’s in-the-money, and it expires in three months. Your position is skyrocketing, but you didn’t choose a price where you’d exit the position. You’re intoxicated by the gains you’re making, and then all of a sudden Elon tweets that Tesla doesn’t accept bitcoin anymore, and it shreds all of your potential profits.
Instead of chasing those little dopamine bursts when you profit, just practice discipline, and do not get greedy. This means that even if the position is moving in a favorable direction, you still want to make a plan on when to exit the potion. In this way you can minimize losses, and start stacking more gains, more consistently.
2. Liquidity Slips Your Mind
Say you’re selling two phones on Craigslist. One is an iPhone 3gs, and the other is an iPhone 11. It’s more likely that you’ll sell the iPhone 11 faster, and closer to the price you want, because there is a larger market with more demand for that phone. We can call this larger market a ‘liquid’ market.
I mean, who wants an iPhone 3gs? Maybe somebody, but because the market is smaller for the 3gs, it will probably take you a long time to find the right buyer. The only way you’ll be able to sell it quicker, is if you sell it at a major discount. This smaller market, which ultimately stems from small demand, can be referred to as an ‘illiquid’ market.
This is similar to how liquidity affects your trades in the market. If a contract’s liquidity is higher, your trade will likely execute faster. If the liquidity is lower, your trade will likely take longer to go through. The longer it takes for a trade to execute, the higher the chance it is for the price of the option to move further away from what you wanted. Trading illiquid options opens yourself up to unnecessary risk you can avoid by just checking what the trade volume is—plus, liquidity and trading volumes can change overnight, even for typically stable assets like bonds.
Here are two tips to help you avoid issues with liquidity:
First, buy contracts with a trade volume of at least a million. We consider a trade volume higher than a million to be liquid, and less than a million to be illiquid. Purchasing liquid contracts will help better ensure you have a buyer or seller on the other end so that you have a higher chance of executing your trade at the price you want.
Second, if you have a specific price you want to buy or sell an option, place a limit order. Limit orders ‘limit’ the price you buy or sell the contract at your specified price.
3. Blindly Choosing an Expiration Date
The clock is ticking! Don’t jump the gun choosing an option contract without first seriously considering the expiration date.
Remember, options tend to decay in value as time passes. If your position is moving in an unfavorable direction, it’s probably a good idea for you to pull out because it’s only going to keep losing time value. In the unlikely scenario that the position rebounds and you could’ve profited, don’t get discouraged, know that you made the best statistical decision (remember – sticking to your strategy in the long-term is much more important than large, one-off gains). This will save you from huge losses in the future.
Another factor to consider is, what happens if you long a call option on May 1st, and it expires on July 1st, but the underlying company’s earnings report will be released June 30th? Very often, a stock’s price will have significant movement after an earnings report is released. If you’re caught in the middle of this, your contract could move out-of-the-money and lose it’s value.
In general, it’s a good idea to make sure that there aren’t large events occurring while you long a contract that could significantly influence the price of the underlying stock. While it’s possible to win big, it’s also possible to lose big. Ask yourself if you’re willing to take that risk. Some examples of these noteworthy events include:
- Major holidays like Christmas and New Years
- Earnings reports (as discussed above)
- Stock splits
- Dividend payouts
- Major elections
All of these events often cause large market swings, and your safest bet is to make sure you aren’t caught in the middle of them.
4. Forgetting to Use the Power of Probability
“Risk equals reward” is one of, if not the most fundamental principles when you trade in the stock market.
How does this concept apply to options trading?
Here’s how: Generally speaking, the longer out the expiration date of an options contract is, the higher the chance it will move more in-the-money, thus less risky. This is why contracts that are in-the-money, with an imminent expiration, are more expensive than a contract that is out-of-the-money with the same expiration date.
As a general rule, the riskier the contract, the less expensive the premium, and visa versa. Here’s a scenario that highlights risk equaling reward:
You assume more risk if you purchase a call contract that’s out-of-the-money than you would if it’s in-the-money. If the stock’s value goes above the strike price before expiration, and you long the contract that is out-of-the-money to begin with, your reward will be greater than if you had longed the contract that was in-the-money.
Remember that if there is a possibility of the underlying stocks price to increase greatly, the inverse is possible also. What you think could be a large reward could turn into a detrimental loss. So first, look at a probability chart and the potential prices the contract could reach in different increments of time. Next, assess your level of risk. Ask yourself how risk averse you are.
What if you need to exercise a contract — which ultimately drains a huge portion of your capital? Can you sustain a big loss?
These are just a couple important factors to consider before blindly entering positions. You don’t want to gamble away your capital. You want to make the most statistically sound decision, and you can use probability indicators to increase the strength of your decision.
This is one useful example of overlaying what are called Bollinger Bands on a stock’s chart. The orange line is the 20-day moving average (you can change the number of days if you’d like). The two tiny lines above and below the orange line are 2 standard deviations away from the moving average. This type of indicator can help you make predictions on the future movement of a stock’s price.
One way to do this is by seeing where the current price is within the bollinger bands. If the price is scraping the top band (like it is in the above image), that typically means the price will fall closer to it’s average, as indicated by the most recent candle on the chart. Same rule applies if the price is scraping the bottom, or slightly protruding out of the line, it causes the stock price to move back towards it’s moving average.
5. Neglecting Your Friends, the Greeks
The greeks are important characters in the world of options. Much like the beta of a stock, they can give you helpful clues that you can imbue into a trade decision.
But, also similar to a stock’s beta, it should not be the sole indicator used in your decision-making process. The more information you can imbue into a decision, the higher the chance you’re making a statistically viable trade for yourself. Collect data, and aggregate it into a single move.
It would be a mistake not to at least review the greeks when you’re thinking about trading options. Let’s go over some basic info to help you get started so you can use them to your advantage.
What are the Greeks? We’ll go over what we find to be the two most important out of the 4 (delta, gamma, theta, and vega). Delta is the expected change in the price of an option based on a $1 movement in the underlying stock’s price. So if an option has a delta of $0.25, and the underlying stock moves $1, the price of the call option should move $0.25. Here are some key factors of delta:
- A call option can have a delta between 0 and 1
- For ITM options, as expiration nears, delta gets closer to 1
- For OTM options, as expiration nears, delta get closer to 0
- At the money (ATM) options typically have a delta close to 0.5
Helpful tip: While you might not find this in a standard definition of delta, delta can be used as one indicator of whether or not a call option will expire ITM.
The second greek that’s important to note is theta. Theta relates to the options time value; it is the amount the price of an option will move with respect to a one day move closer to the contract’s expiration.
So again, think of your option like an ice cream cone in the summer, for every minute that passes, it melts – just like the time value of your contract. A key factor to note: as expiration approaches, the rate at which the option price ‘melts’ is accelerated.
To Wrap Up, Learn From The Mistakes of Others
Time decay is the bane of options traders, use theta to your advantage, and be mindful when choosing an expiration date. Probability is obviously not a guarantee, but using basic charts (like the one pictured above) and the power of delta, will statistically improve your chances of success.
Importantly, never forget liquidity. You can spend a lot of time making a plan—setting a price to enter and exit, mindfully choose your expiration date, and heed the greeks. But, if the contract isn’t very liquid, you could be in big trouble, wasting your hard work, time, and money.
We’ve highlighted some of the most common mistakes when trading options. If you bear these in mind, you’ll learn from the mistakes of others and put yourself a few steps ahead of the rest, avoiding unnecessary heartache in the dynamic world of options.
Lastly, leave your emotions at the door! There’s no room for emotions in the world of trading. You’re not looking for big wins – you’re looking for long-term, sustainable growth. This is achieved through a consistent focus on risk management. This is a key principle of our trading philosophy here at The Trading Analyst. Learn more about our options trading strategy to understand how it works – and why it’s successful.
Best of luck!