Today’s Trading Lesson From TradingMarkets

  • June 3, 2005
  • TradingMarkets Editors

Editor’s Note:

Each night we feature a different lesson from



TM University. I hope you enjoy and profit from these.
E-mail me if you have
any questions.

Brice

PS To learn professional options strategies, try the

TradingMarkets Options College.

Seven Mistakes
Novice Options Traders Make

By Len Yates

  1. 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.

  2. 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.



  3. 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.

  4. 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.

  5. 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.

  6. (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.

  7. 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

  1. “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.

  2. “Options
    are too complex.” 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.

  3. “Options
    are too expensive.” On the
    contrary, options can be bought for as little as a few hundred dollars each.



1Extract
from the forthcoming book,
“The Global Investor Book Of Investing Rules.”