Today’s Trading Lesson From TradingMarkets

  • June 29, 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

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.” 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.

     


  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.”