7 Mistakes Novice Options Traders Make
Thinking of an option like a stock. An option can go to zero much faster than a stock! You have to act quickly if it starts to go the wrong way.
Buying out-of-the-money options because they’re cheaper. Yes, they’re cheaper, but they’re less likely to reward you with a gain because you’re asking the underlying to jump through a smaller hoop. Buy a smaller quantity of in-the-money options and you’ll be more satisfied with the behavior of your option as the stock jiggles and chops its way in your direction.
Buying options without regard for the current volatility level. Recent volatility makes options more expensive. If you buy expensive options, you may be hurt when the market settles back down.
Thinking that covered writing both lowers your risk and increases expected return. Covered writing (selling calls against shares of stock) is often presented using numbers like “return if stock unchanged” and “return if stock is called away,” both very favorable outcomes. When the whole picture is considered (including the stock going way down or way up), covered writing lowers risk and lowers expected returns.
Believing that there is a certain option strategy (e.g., covered writing, vertical spreads, horizontal spreads, etc.) that has positive expected returns in the long run. There is no magic options strategy that makes money. Traders must pick a strategy to apply in each situation that sets up the desired risk/reward profile.
(Extension of #5) Believing that selling options (naked or covered) has positive expected returns in the long run. Don’t get too concerned with the time decay nature of options. An option’s time decay is offset by potential movement in the underlying. The result: A fairly valued option conveys no edge to a seller or a buyer.
Lack of preparation and education. Read a book or two, attend a seminar, select good trading software, and do some “paper” trading before diving into the real thing. When ready, select an options-friendly brokerage, and start trading with small, easily manageable positions.
Three reasons investors mistakenly avoid trading options1
“Options are too risky.” Although options can be used to speculate on short-term moves, they can also be used to lower the risk of a stock portfolio. They can also be used in place of stocks to invest in long-term (up to three years) moves. There are many different ways of using options, some of them risky, some of them not.
“Options are too complex.” This is a myth. Options are kind of like the game of chess. You can learn the rules and be ready to play in just 20 minutes! Of course, then there’s a few strategies you need to become familiar with. However, while chess variations are practically infinite, in options there are just a handful of different strategies, and it’s not necessary to know them all before you get started.
“Options are too expensive.” On the contrary, options can be bought for as little as a few hundred dollars each.
1Extract from the book, “The Global Investor Book Of Investing Rules.”