When trading options, it’s possible to profit if stocks go up, down or sideways. You can use options strategies to cut losses, protect gains and control large chunks of stock with a relatively small cash outlay.
Sounds great, right? Here’s the catch: You can lose more money than you invested in a relatively short period of time when trading options. This is different than when you purchase a stock outright. In that situation, the lowest a stock price can go is $0, so the most you can lose is the amount you purchased it for. With options, depending on the type of trade, it’s possible to lose your initial investment — plus infinitely more.
That’s why it’s so important to proceed with caution. Even confident traders can misjudge an opportunity and lose money.
To help you avoid potentially costly mistakes, we’re covering the top 10 mistakes typically made by beginner option traders with the help of our in-house options guy Brian Overby.
#1 Option trading mistake: Buying Out-of-the-Money (OTM) call options
Purchasing OTM call options seems like a good place to start for new options traders because they are low cost. Buy a cheap call option and see if you can pick a winner. This may feel safe because it matches the pattern you’re used to following as an equity trader: buy low and try to sell high. But they are one of the hardest ways to make money consistently in options trading. If you limit yourself to only this strategy, you may lose money more often than you make a profit.
How to trade smarter
Consider selling an OTM call option on a stock that you already own as your first strategy. This approach is known as a covered call strategy.
What’s nice about covered calls as a strategy is the risk does not come from selling the option when the option is covered by a stock position. It also has potential to earn you income on stocks when you’re bullish but are willing to sell your stock if it goes up in price. This strategy can provide you with the “feel” for how OTM options contract prices change as expiration approaches and the stock price fluctuates.
The risk, however, is in owning the stock — and that risk can be substantial. Although selling the call option does not produce capital risk, it does limit your upside, therefore creating opportunity risk. You risk having to sell the stock upon assignment if the market rises and your call is exercised.
Want to develop your own option trading approach? The Options Playbook is your essential resource for learning about and building options strategies.
#2 Option trading mistake: Misunderstanding leverage
Most beginners misuse the leverage factor offered by option contracts, not realizing how much risk they’re taking. They’re often drawn to buying short-term calls. Since this is the case so frequently, it’s worth asking: Is the outright buying of calls a “speculative” or “conservative” strategy?
Before you answer the speculative-or-conservative question about long calls, consider the theoretical case of Peter and Linda presented in the video below. They both have $6,000 to invest.
How to trade smarter
Master leverage. General rule for beginning option traders: If you usually trade 100 share lots, then stick with one option to start. If you normally trade 300 share lots, then maybe try three contracts. This is a good test amount to start with. If you don’t have success in these sizes, you will most likely not have success with the bigger size trades.
#3 Options trading mistake: Having no exit plan
You’ve probably heard it before: When trading options, just like stocks, it’s critical to control your emotions. This doesn’t mean swallowing your every fear in a super-human way. It’s much simpler than that: Make a plan and stick to it.
This includes having an exit plan, even when things are going your way. Choose an upside exit point, a downside exit point and your timeframes for each exit well in advanced.
If you feel yourself thinking the classic trader’s worry, “What if I get out too early and leave some upside on the table?” remember this counterargument: What if you make a profit more consistently, reduce your incidence of losses and sleep better at night?
How to trade smarter
Define your exit plan. Whether you are buying or selling options, an exit plan can help you establish more successful patterns of trading and keep your worries in check.
Whether you are buying or selling options, an exit plan can help you establish more successful patterns of trading and keep your worries in check.
Determine an upside exit plan and the worst-case scenario you are willing to tolerate on the downside. If you reach your upside goals, clear your position and take your profits. Don’t get greedy. If you reach your downside stop-loss, once again you should clear your position. Don’t expose yourself to further risk in hopes that the options price might come back.
The temptation to go against this mindset will probably be strong from time to time. Don’t do it. Too many traders set up a plan and then, as soon as the trade is placed, toss their strategy in favor of following their emotions.
#4 Options trading mistake: Not being open to new strategies
Many option traders say they would never buy out-of-the-money options or never sell in-the-money options. These absolutes seem silly — until you find yourself in a trade that’s moved against you.
All seasoned options traders have been there. Facing this scenario, you’re often tempted to break all kinds of personal rules.
As a Self-Directed stock trader, you’ve probably heard a similar justification for doubling up to catch up. For example, if you liked the stock at $80 a share when you bought it, you’ve got to love it at $50 a share. It can be tempting to buy more and lower the net cost basis on the trade. Be wary, though: What makes sense for stocks might not fly in the options world. Doubling up as an option strategy usually just doesn’t make sense.
How to trade smarter
Be open to learning new options trading strategies. Remember, options are derivatives, which means their prices don’t move the same or even have the same properties as the underlying stock. Time decay, whether good or bad for the position, always needs to be factored into your plans.
When things change in your trade and you’re contemplating the previously unthinkable, just step back and ask yourself: Is this a move I’d have taken when I first opened this position?
If the answer is no, then don’t do it.
Close the trade, cut your losses or find a different opportunity that makes sense now. Options offer great possibilities for leverage on relatively low capital, but they can blow up just as quickly as any position if you dig yourself deeper. Be willing to take a small loss when it offers you a chance of avoiding a catastrophe later.
#5 Options trading mistake: Trading illiquid options
Liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers always.
Here’s another way to think about it: Liquidity refers to the probability that the next trade will be executed at a price equal to the last one.
Stock markets are more liquid than option markets for a simple reason. Stock traders are trading just one stock while option traders may have dozens of option contracts to choose from.
For example, stock traders will flock to one form of IBM stock, but options traders could have six different expirations and a plethora of strike prices to choose from. More choices, by definition, means the options market will probably not be as liquid as the stock market.
A large stock like IBM is usually not a liquidity problem for stock or options traders. The problem creeps in with smaller stocks. Take SuperGreenTechnologies, an (imaginary) environmentally friendly energy company with some promise, which might only have a stock that trades once a week by appointment only.
If the stock is this illiquid, the options on SuperGreenTechnologies will likely be even more inactive. This will usually cause the spread between the bid and ask price for the options to get artificially wide.
For example, if the bid-ask spread is $0.20 (bid=$1.80, ask=$2.00), and if you buy the $2.00 contract, that’s a full 10% of the price paid to establish the position.
It’s never a good idea to establish your position at a 10% loss right off the bat, just by choosing an illiquid option with a wide bid-ask spread.
How to trade smarter
Trading illiquid options drives up the cost of doing business, and options trading costs are already higher, on a percentage basis, than stocks. Don’t burden yourself.
If you are trading options, make sure the open interest is at least equal to 40 times the number of contacts you want to trade.
For example, to trade a 10-lot, your acceptable liquidity should be 10 x 40, or an open interest of at least 400 contracts. Open interest represents the number of outstanding options contracts of a strike price and expiration date that have been bought or sold to open a position. Any opening transactions increase open interest, while closing transactions decrease it. Open interest is calculated at the end of each business day. Trade liquid options and save yourself added cost and stress. Plenty of liquid opportunities exist.
Want more expert insight into stock market conditions, trends and more? Ally Invest’s Brian Overby weighs in every week to keep you informed, up to date and ready to trade at Stock Play of the Day on YouTube.
#6 Options trading mistake: Waiting too long to buy back short options
This mistake can be boiled down to one piece of advice: Always be ready and willing to buy back short options early.
Far too often, traders will wait too long to buy back the options they’ve sold. There are a million reasons why. For example:
You don't want to pay the commission.
You're hoping to eke just a little more profit out of the trade.
You're betting the contract will expire worthless.
How to trade smarter
Know when to buy back your short options. If your short option gets way OTM and you can buy it back to take the risk off the table profitably, do it. Don’t be cheap.
For example, what if you sold a $1.00 option and it’s now worth 20 cents? You wouldn’t sell a 20-cent option to begin with, because it just wouldn’t be worth it. Similarly, you shouldn’t think it’s worth it to squeeze the last few cents out of this trade.
Here’s a good rule of thumb: If you can keep 80% or more of your initial gain from the sale of the option, you should consider buying it back. Otherwise, it’s a virtual certainty. One of these days, a short option will bite you back because you waited too long.
#7 Options trading mistake: Failure to factor upcoming events
Not all events in the markets are foreseeable, but there are two crucial events to keep track of when trading options: earnings and dividend dates for your underlying stock.
For example, if you’ve sold calls and there’s a dividend approaching, it increases the probability you may be assigned early if the option is already in-the-money. This is especially true if the dividend is expected to be large. That’s because options owners have no rights to a dividend. To collect, the options trader must exercise the option and buy the underlying stock.
How to trade smarter
Be sure to factor upcoming events. For example, you must know the ex-dividend date. Also, steer clear of selling options contracts with pending dividends, unless you’re willing to accept a higher risk of assignment.
Trading during earnings season typically means you’ll encounter higher volatility with the underlying stock — and usually pay an inflated price for the option. If you’re planning to buy an option during earnings season, one alternative is to buy one option and sell another, creating a spread. (See Mistake 8 below for more information on spreads).
Understanding implied volatility can also help you make more informed decisions about an options contract’s current price and potential future movements. Implied volatility is derived from an option’s price and shows what the market implies about the stock’s volatility in the future. While implied volatility won’t tell you which way a stock will move, it can help you understand whether it may make a large or minor movement. Keep in mind, the higher the option premium, the higher the implied volatility.
#8 Options trading mistake: Legging into spreads
Most beginner options traders try to “leg into” a spread by buying the option first and selling the second option later. They’re trying to lower the cost by a few pennies. It simply isn’t worth the risk.
Sound familiar? Many experienced options traders have been burned by this scenario, too, and learned the hard way.
How to trade smarter
Don’t “leg in” if you want to trade a spread. Trade a spread as a single trade. Don’t take on extra market risk needlessly.
For example, you might buy a call and then try to time the sale of another call, hoping to squeeze a little higher price out of the second leg. This is a losing strategy if the market conditions take a downturn because you won’t be able to pull off your spread. You could be stuck with a long call and no strategy to act upon.
If you are going to try this trading strategy, don’t buy a spread and wait around hoping the market will move in your favor. You might think that you’ll be able to sell it later at a higher price, but that’s an unrealistic outcome.
Always treat a spread as a single trade rather than try to deal with the minutia of timing. You want to get into the trade before the market starts going down.
Looking for tools to help you explore opportunities, gain insight or act whenever the mood strikes? Check out the intelligent tools on our trading platform.
#9 Options trading mistake: Not knowing what to do when assigned
If you sell options, remind yourself occasionally that you can be assigned early, before the expiration date. Lots of new options traders never think about assignment as a possibility until it happens to them. It can be jarring if you haven’t factored in assignment, especially if you’re running a multi-leg strategy like long or short spreads.
For example, what if you’re running a long call spread and the higher-strike short option is assigned? Beginning traders might panic and exercise the lower-strike long option to deliver the stock. But that’s probably not the best decision. It’s usually better to sell the long option on the open market, capture the remaining time premium along with the option’s inherent value, and use the proceeds toward purchasing the stock. Then you can deliver the stock to the option holder at the higher strike price.
Early assignment is one of those truly emotional, often irrational market events. There’s not always any rhyme or reason to when it happens. It just happens, even when the marketplace is signaling that it’s a less-than-brilliant maneuver.
How to trade smarter
Think through what you’d do when assigned well ahead of time. The best defense against early assignment is to factor it into your thinking early. Otherwise, it can cause you to make defensive, in-the-moment decisions that are less than logical.
It can help to consider market psychology. For example, which is more sensible to exercise early? A put or a call? Exercising a put or a right to sell stock, means the trader will sell the stock and get cash.
Also ask yourself: Do you want your cash now or at expiration? Sometimes, people will want cash now versus cash later. That means puts are usually more susceptible to early exercise than calls.
Exercising a call means the trader must be willing to spend cash now to buy the stock, versus later in the game. Usually, it’s human nature to wait and spend that cash later. However, if a stock is rising, less skilled traders might pull the trigger early, failing to realize they’re leaving some time premium on the table. That’s how an early assignment can be unpredictable.
#10 Options trading mistake: Ignoring index options for neutral trades
Individual stocks can be quite volatile. For example, if there is major unforeseen news event in a company, it could rock the stock for a few days. On the other hand, even serious turmoil in a major company that’s part of the S&P 500 probably wouldn’t cause that index to fluctuate very much.
What’s the moral of the story?
Trading options that are based on indexes can partially shield you from the huge moves that single news items can create for individual stocks. Consider neutral trades on big indexes, and you can minimize the uncertain impact of market news.
How to trade smarter
Consider trading strategies that could be profitable when the market stays still, such as a short spread (also called credit spreads) on indexes. Index moves tend to be less dramatic and less likely impacted by the media than other strategies.
Short spreads are traditionally constructed to be profitable, even when the underlying price remains the same. Therefore, short call spreads are considered “neutral to bearish” and short put spreads are “neutral to bullish.” This is one key difference between long spreads and short spreads.
Remember, spreads involve more than one option trade, and therefore incur more than one commission. Keep this in mind when making your trading decisions.
Expand your options with smart options trades
Trading options can be a great strategy for diversifying your portfolio, limiting risk and generating profit — when executed well. Of course, it’s important to remember that no trades are risk-free, and options can result in major losses if you aren’t careful. By familiarizing yourself with these common mistakes, you’ll have a better chance of recognizing and stopping them before they happen.
Brian Overby is a widely sought-after resource for his option trading knowledge and market insights. He has contributed to numerous articles for the Wall Street Journal, Reuters, and Bloomberg, and has had frequent appearances on CNBC Fast Money and Fox Business News. A veteran of the financial industry since 1992, Brian continually seeks to improve the understanding of the retail investor. He has given thousands of option trading seminars worldwide, written hundreds of articles on investing, and is the author of the popular trading resource The Options Playbook. Brian was a senior staff instructor for the Chicago Board Options Exchange (CBOE) and managed the training department for one of the world’s largest market makers, Knight Trading Group.
