Mistake 1: Starting out by buying out-of-the-money (OTM) call options
It seems like a good place to start: buy a call option and see if you can pick a winner. Buying calls may feel safe because it matches the pattern you’re used to following as an equity trader: buy low, sell high. Many veteran equities traders began and learned to profit in the same way.
However, buying OTM calls outright is one of the hardest ways to make money consistently in the options world. If you limit yourself to this strategy, you may find yourself losing money consistently and not learning very much in the process. Consider jump-starting your options education by learning a few other strategies, and improve your potential to earn solid returns as you build your knowledge.
What’s wrong with just buying calls?
It’s tough enough to call the direction on a stock purchase. When you buy options, however, not only do you have to be right about the direction of the move, you also have to be right about the timing. If you’re wrong about either, your trade may result in a total loss of the option premium paid.
Each day that passes when the underlying stock doesn’t move, your option is like an ice cube sitting in the sun. Just like the puddle that’s growing, your option’s time value is evaporating until expiration. This is especially true if your first purchase is a near-term, way out-of-the-money option (a popular choice with new options traders because they’re usually quite cheap).
Not surprisingly, though, these options are cheap for a reason. When you buy an OTM “cheap” option, they don’t automatically increase just because the stock moves in the right direction. The price is relative to the probability of the stock actually reaching (and going beyond) the strike price. If the move is close to expiration and it’s not enough to reach the strike, the probability of the stock continuing the move in the now shortened timeframe is low. Therefore, the price of the option will reflect that probability.
How can you trade more informed?
As your first foray into options, you should consider selling an OTM call on a stock that you already own. This strategy is known as a “covered call”. By selling the call, you take on the obligation to sell your stock at the strike price stated in the option. If the strike price is higher than the stock’s current market price, all you’re saying is: if the stock goes up to the strike price, it’s okay if the call buyer takes, or “calls”, that stock away from me.
For taking on this obligation, you earn cash from the sale of your OTM call. This strategy can earn you some income on stocks when you’re bullish, but you wouldn’t mind selling the stock if the price goes up prior to expiration.
What’s nice about covered call selling, or “writing,” as a starter strategy is that the risk does not come from selling the option. The risk is actually in owning the stock – and that risk can be substantial. The maximum potential loss is the cost basis of the stock less the premium received for the call. (Don’t forget to factor in commissions, too.)
Although selling the call option does not produce capital risk, it does limit your upside, therefore creating opportunity risk. In other words, you do risk having to sell the stock upon assignment if the market rises and your call is exercised. But since you own the stock (in other words you are “covered”), that’s usually a profitable scenario for you because the stock price has increased to the strike price of the call.
If the market remains flat, you collect the premium for selling the call and retain your long stock position. On the other hand, if the stock goes down and you want out, just buy back the option, closing out the short position, and sell the stock to close the long position. Keep in mind you may have a loss in the stock when the position is closed.
As an alternative to buying calls, selling covered calls is considered a smart, relatively low-risk strategy to earn income and familiarize yourself with the dynamics of the options market. Selling covered calls enables you to watch the option closely and see how its price reacts to small moves in the stock and how the price decays over time.
Mistake 2: Not having a definite exit plan prior to expiration
You’ve heard it a million times before. In trading options, just like stocks, it’s critical to control your emotions. This doesn’t mean swallowing your every fear in a super-human way. It’s much simpler than that: have a plan to work, and work your plan.
Planning your exit isn’t just about minimizing loss on the downside. You should have an exit plan, period – even when things are going your way. You need to choose in advance your upside exit point and your downside exit point, as well as your timeframes for each exit.
What if you get out too early and leave some upside on the table?
This is the classic trader’s worry. Here’s the best counterargument I can think of: What if you make a profit more consistently, reduce your incidence of losses, and sleep better at night? Trading with a plan helps you establish more successful patterns of trading and keeps your worries more in check.
How can you trade more informed?
Whether you are buying or selling options, an exit plan is a must. Determine in advance what gains you will be satisfied with on the upside. Also determine the worst-case scenario you are willing to tolerate on the downside. If you reach your upside goals, clear your position and take your profits. Don’t get greedy. If you reach your downside stop-loss, once again you should clear your position. Don’t expose yourself to further risk by gambling that the option price might come back.
The temptation to violate this advice will probably be strong from time to time. Don’t do it. You must make your plan and then stick with it. Far too many traders set up a plan and then, as soon as the trade is placed, toss the plan to follow their emotions.
Mistake 3: Compromising your risk tolerance to make up for past losses by “doubling up”
I’ve heard many option traders say they would never do something: “…never buy really out-of-the-money options!”, “…never sell in-the-money options!” It’s funny how these absolutes seem silly – until you find yourself in a trade that’s moved against you.
All seasoned options traders have been there. Facing this scenario, you’re often tempted to break all kinds of personal rules, simply to keep on trading the same option you started with. Wouldn’t it be nicer if the entire market was wrong, not you?
As a stock trader, you’ve probably heard a similar justification for “doubling up to catch up”: if you liked the stock at 80 when you bought it, you’ve got to love it at 50. It can be tempting to buy more and lower the net cost basis on the trade.
Be wary, though: What makes sense for stocks might not fly in the options world.
How can you trade more informed?
“Doubling up” as an options strategy usually just doesn’t make sense. Options are derivatives, which means their prices don’t move the same or even have the same properties as the underlying stock. Time decay, whether good or bad for the position, always needs to be factored into your plans.
When things change in your trade and you’re contemplating the previously unthinkable, just step back and ask yourself: “Is this a move I’d have taken when I first opened this position?” If the answer is no, then don’t do it.
Close the trade, cut your losses, or find a different opportunity that makes sense now. Options offer great possibilities for leverage on relatively low capital, but they can blow up just as quickly as any position if you dig yourself deeper. Take a small loss when it offers you a chance of avoiding a catastrophe later.