The incredible thing about trading options is that you can make money if equities rise, fall, or remain flat.
In addition to this - with very little money down - you can use options to limit losses, safeguard your profits, or control a huge amount of shares.
Sounds pretty incredible, doesn't it?
But, there is an issue.
The issue is that while trading options, you can lose more than you invested when using certain option strategies. Trading options is not the same as purchasing a stock outright. The lowest a stock price can go in such case is $0, so the most you can lose is the amount you paid for it. But when you're trading options, it's possible to lose your initial investment — plus a lot more — if you sell options.
That is why it's critical to approach option trading with caution. Even the most experienced traders can make a mistake and lose a lot of money.
If you're new to options trading, we highly recommend you follow a more experienced trader's trades when you start out. In fact, we've put together some options trading alerts service reviews to help you choose the service that's right for you.
So in this article, we'll go through some of the most common blunders that new option traders often make to help you avoid making potentially costly mistakes.
Mistake #1: Buying Out-of-the-Money (OTM) Call Options
Because OTM call options are inexpensive, they appear to be a fantastic place to start for beginning options traders.
Many think this is a great way to get started, as they can buy a low-cost call option to see if you can predict the winner.
You might think that this is pretty safe s it follows the general pattern you've used before when trading stocks: you buy cheap and sell high. But there are a lot of other factors to keep in mind when buying options. And if you don't keep them in mind before placing your trade, you will probably lose more than you win.
To combat this, many recommend on opening a Covered Call by selling an OTM call option on a stock you currently own.
The benefit of using covered calls as a strategy is that the risk of selling the option is eliminated when the option is covered by a stock you're already holding. So if the price of the stock remains below the call you sold, you keep all the money you made when you sold the call.
The danger is that if the stock appreciates past the strike of your call on the options expiration. If this happens, you will have to sell your stock.
Mistake #2: Misunderstanding Leverage
Most newbies take advantage of the leverage provided by option contracts without really understanding how much risk they are taking. Most get sucked into purchasing short-term calls. While this can be a good strategy if there is a short term catalyst (such as an earnings report) happening before the call expires, it's really an "all or nothing" type trade.
Regardless of the strategy you use, beginner option traders should start by trading only one option contract per 100 shares they normally trade when they trade stocks.
So if they normally trade 200 shares, they would start by trading 2 options contracts, as each option contract generally controls 100 shares.
It's important to gradually get used to the leverage that you have when trading options, because if you can't succeed trading with a smaller amount first, adding more leverage will only blow up your trading account.
Mistake #3: Having No Exit Plan When Trading Options
I'm sure that you've heard the saying that controlling your emotions is crucial when trading.
And it's true regardless of whether you're trading stocks or options.
Of course, this doesn't mean that you try to ignore all your fears and push through - it simply means making a plan and following it regardless of how you feel at the moment.
This means that you need to follow the plan even when things are going well.
Follow your pre-determined stop and profit taking levels and the timelines for each trade.
Remember: even if you close a trade early and feel that you left money on the table, profit is still profit.
And on the downside, make sure you determine your exit point.
Doing this beforehand will help eliminate a lot of the emotion that involved in trading and allow you to enter and exit trades more precisely.
You will always be tempted to ignore your plan when you're trading in the moment, but don't do it.
This is when having the discipline to stick to your plan is crucial.
Mistake #4: Trading Illiquid Options
Liquidity refers to a trader's ability to trade an asset without producing a major price change.
A liquid market is one where there are a lot of eager buyers and sellers.
The stock market is more liquid than the option markets simply because with each trade, option traders have many different (and more specific) trade options whereas stock traders are only trading long or short.
For example at any given time, traders can either buy or sell shares of Tesla.
But options traders have many different strike prices and expiration dates to choose from, addition to going long or short.
This specificity divides up the number of people interested in each position which makes each trade less liquid when compared to trading the stock.
Now, for big name stocks (think Google, Amazon, Tesla etc.) options liquidity usually isn't a problem.
But it can be a factor on smaller companies, causing a large gap between the bid and ask price of the options spread.
If you open a trade and end up losing 8% just because the option is illiquid, it's going to make it hard for you to make any money.
A general rule of thumb is to try and make sure that the open interest is at least 40 times the number of contacts you intend to trade if you're trading options.
Remember, when trading options take it slow.
Learn, practice on paper, and understand everything before you start trading with real money.