Options can lead to some of the most lucrative rewards.
But they can also lead to substantial, unnecessary losses if traded poorly. Unfortunately, traders of every level make the same mistakes over and over again, ad nauseam and see big losses. The sad part – most of the mistakes could have been avoided, easily.
Mistake No. 1 – Trading without an exit strategy
We’re all guilty of this. We see that our option is down 30%, but if we just hold on for another day, perhaps it’ll turn around. Or, our trade is up 50%, but if we just hold for another day that 50% could be 100%. We’re all guilty of it.
Unfortunately, many of us cannot remove the emotion from the trade.
But to be a successful options trader, you need to plan your exits in advance. Have a plan to work. And always work your plan. No matter what you emotions say, never deviate.
Granted, planning your exit isn’t just about minimizing losses. You should have an exit plan on the long side too. Remember, options are a decaying asset. That rate increases the closer you hold as your expiration date nears. If you’re in a call or put, and the move hasn’t happened in a respectable time frame, jump out and move to the next trade.
Also, while many brokers don’t allow stop losses on options, consider having a mental stop loss in place to jump out should things go against you.
Mistake No. 2 – Trading Illiquid Options
Any time you get an options quote you want to look at the difference between the bid-price and the ask-price. While neither typically reflects what the option is really worth, the real value of the option is somewhere between the bid and the ask price. The closer the bid and the ask prices are can tell you a lot about how liquid the option truly is.
For example, an Apple (AAPL) November 17, 2017-167.50 call option has a liquid bid-ask of $4.15 x $4.20 with open interest of 7,548. That’s easy to spot as a liquid option.
That liquidity tells us there are many active buyers and sellers most times.
In addition, liquidity will keep the bid and ask price closer together. For example, a bid ask price of $2 x $3 is not very close and can indicate an illiquid choice. Also, illiquidity in options pricing becomes worse when you’re also dealing with an illiquid stock.
After all, if the stock isn’t very active, options will also be inactive leading to illiquidity.
For example, let’s say you’re about to place a trade on an illiquid option that carries a bid price of $2 and an ask price of $2.90. Ninety cents may not seem like a lot of money. But it’s not worth buying at all because it’ll go nowhere.
Mistake No. 3 – Choosing the Wrong Position Size
Never risk the house on any trade.
Position sizing errors can stem from fear and greed. If you are too greedy, you could wind up taking a bet that’s far too big. Then, if the trade goes against you, the loss is far too big. Other times, traders take bets that are far too small, which can be a bad thing, too.
Instead, consider risking 1% to 5% of your total portfolio per trade.
Also, consider using a consistent dollar value, such as $500 to $10,000 on a trade. Spread out your money, so it lasts longer.
Ultimately, you need to look at your risk tolerance level.
How much can you afford to lose on a single trade? If you bet $10,000 on a trade, can you reasonably afford to lose $10,000?
These are just a few of the errors that options traders typically make.
Be aware of them and be willing to adjust. Or, you stand to lose it all.