Options Trading is well known among traders as it helps them to earn a good amount of trading profit. It helps in making profits when the costs of stock prices move up, down, or sideways. The additional benefit that options trading provides is that it can be directed with generally low cash reserves. But, there is a catch when talking about options trading. Although this appears to be a simple yet profit-making process, it can result in traders losing more than they acquire and may even lose more than the amount they initially invested. Also, this loss can happen in the short run, and consequently, traders and investors opting for options trading need to be cautious while proceeding further. Before discovering the mistakes that even confident traders make when trading options, let us first briefly understand what are options.
What is Option Trading?
Options trading allows you to trade stocks, ETFs, etc. at a particular price within a particular date. This kind of trading also allows buyers not to buy the security at a specified price or date.
Although it is a bit more complicated than stock trading, options can help you make relatively large profits if the price of the security goes up. This is because you do not have to pay the full price for the security in an options contract. In the same way, options trading can limit your losses if the price of a security goes down, which is known as hedging. The right to buy a security is known as a 'Call', while the right to sell is called a 'Put'.
Mistakes Avoid in Options Trading
Buying Out of the Money (OTM) Call Options
Traders, especially those who are new to options trading, end up buying out-of-the-money options. These options are typically less expensive and also popular among traders. The key here that traders should remember is that the value of the option purchased will decrease and hence the contract may either go up or down before the option expiration date. If a favorable movement occurs, you can recover the purchase cost of your options. However the OTM options are profitable, the profit earned is not steady. Consequently, they are not reasonable for an unstable market.
Making the Most of Your Options Trades
As a beginner in options trading, it is generally a common mistake to abuse the leverage offered by options contracts. At the same time, traders frequently ignore the risk factor involved in options trading and end up only focusing on the low cost of options contracts. To prevent losses from options trading, understand leverage well in advance. The rule of thumb is to stay with one option contract in the beginning if you trade in 100 shares. This is also considered a decent testing amount. If you fail to succeed in these lot sizes, chances are that you will hardly succeed with larger lot sizes when trading options.
Trading Illiquid Options
If you are a singular trader, be careful with the distinction between the bid value (the price at which you can sell an option) and the asking value (the price at which you can buy the option). This is known as diffusion. More liquid options will have narrower bid and ask prices, such as a nickel or dime differential. The most liquid options on some contracts will have a penny difference. The average daily volume of a contract and its open interest can also be indicators of liquidity, although sometimes open interest may be due for only a day or two of trading during the life of the contract, depending on the position.
The average daily volume of a contract and its open interest can also be indicators of liquidity, although sometimes open interest may be due for only a day or two of trading during the life of the contract, depending on the position. If you are consistently trading illiquid contracts with more extensive spreads - selling bids and buy offers - then you are facing a significant downside. In such circumstances, work on orders by placing limit orders between the bid and request to see at what point they will fill the order. If they don't fill it out, cancel the order and try again. Keep in mind that in more liquid situations where there is good volume and a restricted spread, there is a chance that you can buy an option at the bid, or sell at its ask. After some time, this can give you an advantage.
Wrong Allocation of Capital
When buying options, there are numerous chances to make profits of 100%, 200%, and surprisingly more in periods, and such profits can be achieved on relatively small moves in the underlying market. But depending on the type of options you are buying, there is also the possibility that you could lose 100% of the dollars invested in a particular trade. Therefore, given the risk of a total loss on a single trade, but the strong potential to double, triple or even quadruple your money, what you do for dollars trading options is comparable to what you trade with stocks. By doing this, you have the potential to make profits similar to that of a stock trader, but with significantly less money at risk.
No Exit Plan
You've probably heard it before: In trading options, just like stocks, it's important to control your emotions. This doesn't mean swallowing your every fear in a godlike manner. It's much simpler than that: Make a plan and stick to it.
This includes planning an exit, even when things are turning out well for you. Pick a potential exit point, a negative exit point, and your time frame for each exit in an advanced way.
Trading in options can be one of the easiest ways to get rich but this only happens when traders can follow the basic rules of options trading. Options contracts can cause more losses than they generate profits and should therefore be a part of a diversified portfolio. Avoid making the mistakes mentioned above so that you do not get stuck in trades that lead to frequent losses. Sign up for the upcoming Free Spiking Webinar where Dr. Clemen Chiang will be teaching you how you can maximize your financial growth, and learn strategies on options trading. Register for free here.
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*Disclaimer: The article should not be taken as, and is not intended to provide investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. Spiking strongly recommends that you perform your own independent research before making financial decisions.