The Most Common Mistakes in Options Trading and How to Avoid Them

Everybody makes mistakes. Anyone can make mistakes. And sometimes it’s even good to make mistakes.

Mistakes are also permitted in stock exchange trading. They are even sometimes unavoidable, especially if you are approaching the big game of options trading for the first time. If you learn from those mistakes, they will help you become a smarter and, step by step, a more successful trader in the long-term.

The only important thing is not to make any fatal mistakes. Fatal errors are errors that destroy a repository: The trader is broke and therefore no longer able to trade. Worse still: The trader is obliged to make additional payments due to his trading flaws. He’s losing more than his initial bet. Entering into trades whose profit probabilities are too low to be successful in the long run is also one of the typical beginner mistakes to avoid.
It’s a fallacy, by the way, to think that bad mistakes only happen to beginners or amateurs. Even investment professionals are not immune to trading mistakes. How many funds, banks and exchange gurus have already gone bankrupt due to their misfortunes?

The following six mistakes are typical errors committed by options traders. They are each provided with tips to avoid them. With the slogan “Whoever is warned is doubly on their guard”, every options trader should understand these possible costly mistakes before even starting to trade options actively.

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Mistake No. 1 in options trading: The purchase of cheap call options

The purchase of call options that are out of the money (i.e. whose strike price is higher than the current price of the underlying asset) offers the trader little chance of successfully earning money.

Such options are tempting for the layman: they are usually cheap, and their leverage promises high profits. Due to their construction, they even correspond to a very well-known stock exchange wisdom: “Buy cheap, sell expensive”. What sounds very good at first sight has a catch, however, which is explained using the following example:
Let’s take the Starbucks share as an example (ticker: SBUX). A trader has a very favourable opinion about this stock and thinks that the Starbucks stock, which currently stands at around $87.70 (as of July 5, 2019), will rise well over $90 in the coming weeks. He buys the call option with a term of 20.09.2019 and a strike price of $90. This call costs him “only” about $221 per contract. More than that $221 the trader can’t lose.

At what share price will the trader start making a profit? By how many percent does the share have to rise in order to generate this profit? In which price range do the losses occur? These are important questions that everyone should ask themselves before entering into such a trade. Let’s look at the profit and loss profile of this trade at the end of the term on 20.09.2019 to answer these questions.

A rapid and robust increase in the share price is necessary to lead the trader into the profit zone!
It is not enough for the stock to rise to make profits with the call option. Only after an increase of 5.1% would a trader break even and the profit zone only starts above a rate of $92.21!
If the share moves sideways in the period between July and September 2019, falls or does not rise by at least 5.1%, the total loss for the trader is sealed.
To be profitable with call options from the money, a trader must be correct with his assessment of the price movement and the stock must move quickly and strongly upward. With this trading approach, the probability of success is not on the trader’s side!

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This is how you avoid this common mistake in options trading:
Instead of buying, an investor should consider short selling a call option out of the money, for shares he already owns in his portfolio. This approach is referred to as the covered call strategy.
This strategy enables the investor to generate profits from the equity position and the premium received for the call option. The premium from the call even minimises his losses if the share should fall. However, it also limits its profits if the stock hits a strong upward trend. But these profits are safer than buying a call option out of the money.

Mistake No. 2 in options trading: Incorrect assessment of the risk of loss

Most beginners misjudge the risk of their options positions in the portfolio. There are significant differences between buying an option and selling an option short. If options are purchased, the risk of loss is limited to the use. However, this bet can be lost very quickly if, for example, the underlying stock does not move rapidly in the desired direction (see error no. 1).
In the case of short selling of options, the risk of loss is theoretically unlimited. The risk is much higher with short sold calls (uncovered, i.e. without holding the corresponding share in the custody account) than with short sold puts.
Take the example of the Coca-Cola share, which costs $51.73 (as of 03/07/2019). A trader sells a put option empty, with a strike price of $50 and a maturity of 45 days. The option costs $0.50. With a multiplier of 100 (1 option equals 100 shares), he collects a premium of $50 per contract. To enter the trade, the broker will require a margin of approximately $800. But that is not the maximum loss risk.
If the share closes above $50 at the end of the term, the put option expires on its own, and the trader retains the premium of $50. If it closes below $50, the trader gets 100 shares booked at the price of $50. If, for example, the stock is quoted at $45, it makes a loss of $450 (a loss of $500 due to the share position, less the premium of $50 already collected). If it falls even lower, for example to $40, the loss is $950 (i.e. higher than the original margin). If the stock falls to $0, which is only a theoretical scenario, in this case, the trader suffers the maximum loss of $4,950.

It is much riskier if the trader decides to sell an uncovered call option empty because he is convinced that the stock will not rise. Assuming he sells a call option on the mentioned share with a strike price of $52.50 and a term of 45 days empty and receives a premium of $79. The broker would charge about $923 as margin. The stock then starts to rise. For example, she’s rapidly climbing to $55. Loss for the trader: ($55 – $52,50) x 100 – $79 = $171. If the stock rises to $65, it’s already a loss of $1,171. Since a share price knows no upper limit, this loss can theoretically extend infinitely.

This is how you avoid this common mistake in options trading:

With short selling put options you should always make sure that you have the necessary money in your account if the stock falls to $0. In this case, one speaks of a Cash-Secured Put. Alternatively, you can buy an additional put option that is still out of the money to limit the risk downwards (this is called a bull put spread).
Short-selling calls are generally not advisable, as the risk of an obligation to make additional contributions and a loss is greater than the stake is very high. Instead, spreads can also be traded here. The call sold short is supplemented with a purchased call that is still out of the money (we speak of a bear call spread). This combination limits the risk of loss through the purchased call, should the stock rise sharply.

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It is essential to be clear before entering a position what the maximum loss of the trade could be. Keep the necessary cash reserves in your custody account to cover this loss.

Mistake No. 3 in options trading: Not having an exit strategy

Getting into a trade can be easy, at least much easier than getting out of a trade again. Once you’re in a trade, emotions usually come into play. Fear and greed alternate as the position develops. If it is in the profit, one does not know whether one should take the profits or hope for still greater profits. If it is in loss, one puzzles whether one should limit these losses and close out the position, or whether one should still give the trade time to recover.
Such situations show that the trader has no plan, and that is a mistake.

This is how you avoid this common mistake in options trading:

You should always have a plan and an exit strategy. This does not necessarily mean that you should bet a stop loss on each position. Especially in options trading, a stop loss makes little sense. However, it means that you should determine which profit target the position should reach to be closed out. Once it has achieved this goal, you should stick strictly to the plan and close the position.

If the position develops against you, a mental price limit should be set (i.e. no active stop loss in the trading platform), above which you should react. This reaction can either be the closing out of the position or, if the strategy permits, the adjustment of the current options. Particularly with combinations of options such as spreads, techniques can be used to “manage” a position that has fallen into difficulties and, ideally, to terminate it lightly.

The temptation to “cling” to a position is likely to be strong from time to time. This can have fatal consequences. The initial plan must not be discarded.

Mistake No. 4 in options trading: Trading of illiquid options

Liquidity is about how quickly an investor can buy or sell something without triggering a significant price movement of the underlying asset. A liquid market is always a market with many active buyers and sellers.
Stock markets are more liquid than option markets for one simple reason. Stock traders trade individual stocks, while options traders may have dozens of options contracts to choose from for a single share.
For example, if you are a pure stock investor and would like to buy Siemens stock, you will have only one choice: Purchase the share. But as an options trader, you can choose from dozens of different maturities and a variety of strike prices. You will not always find a counterparty (buyer or seller) for every single option to enter the trade at favourable price conditions. By definition, the options market is, therefore, not as liquid as the stock market.

A large stock like Google will not pose a liquidity problem for stock or options traders. However, the problem creeps in with smaller companies. For those, you will find a spread between the bid and ask prices for options that are very wide.
For example, if the spread between the bid rate and the ask rate is $0.20 (bid rate: $0.80, ask rate: $1.00) and you buy the option for $1.00, you enter the position with an initial loss of 20%, which must first be recouped. This is not a good place to start.

This is how you avoid this common mistake in options trading:

When trading options, make sure that the so-called open interest is at least 40 times the number of contacts you want to trade. Open interest is the number of outstanding option contracts that have been bought or sold to open a position. When new contracts of an option are traded, the open interest increases. If the contracts are closed out, the open interest is reduced.
For example, if you want to trade a 1 contract, the open interest of the desired option should be at least 40 contracts.

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Mistake No. 5 in options trading: Not taking profits in time

Many investors fail to convert their book profits into cash. There are many reasons for this. Most investors want to save the transaction fees of the trade closure and prefer the automatic worthless expiration of the options. Or they want to squeeze the last dollar of profit out of their current position. Or they remain true to this old and unfortunately very widespread truism: “Let profits run.”
The mistake is that it cannot be ruled out that the profit position will turn into a losing trade after all. The quasi-reliable profits are then lost just because the transaction fees had to be saved. Besides, the current position ties up capital that could be better used for a new, more lucrative position.

This is how you avoid this common mistake in options trading:

Here’s a good rule of thumb: if you can take 50% or more of your original profit from selling the option, you should consider cashing in. Otherwise, you run the risk of missing out on safe profits because you have waited too long or have been too greedy.

Mistake No. 6 in options trading: Disregarding upcoming market events

Not all events in the markets are predictable, but there are two critical events that you should keep in mind when trading options: Quarterly results and dividend dates for your underlying stock.

For example, if you have sold call options and the dividend payment date is just around the corner, you are more likely to exercise the call option early if it is already in the money. This applies in particular when a high dividend is expected because option holders have no right to a dividend. To receive the dividend, the options trader must exercise the option and buy the underlying shares.

Quarterly results can fuel the price of a share or send it down. The impact of these quarterly results on the price of the options is correspondingly large. Even weeks before the quarterly results, an increase in the volatility of the share can be observed. These increased fluctuations usually cause the price of the options to rise. You should be aware of such mechanisms.

This is how you avoid this common mistake in options trading:

Be sure to consider upcoming events. For example, you need to know the ex-dividend date of your shares. Avoid correspondingly selling options that are in the money or close to the money when the dividend payouts are imminent.
If you are very experienced in options trading, you will also be able to trade your option trades well through the reporting season and even profit from it. However, if you have not yet internalised all the mechanisms of options pricing, it is advisable to keep a distance from the options on the underlying stock when quarterly results are forthcoming.

Conclusion:

Once you have understood and internalised the most common mistakes in options trading mentioned above, you are well prepared in your trading, and you can save some decent dollars. Capital preservation is the most important rule in stock exchange trading, whether you trade Forex, CFDs, stocks, options, cryptocurrencies or other financial instruments. Making a profit is only the second step. The six mistakes we’ve just gone through can put your capital at an even higher risk if you commit them than trading complex financial instruments already does. Pay attention to the susceptibility of your trades to errors and the door to future profits is open to you.

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