5 Options Trading Mistakes to Avoid
July 11, 2017, 10:17 am
Whether you’re a seasoned pro or just starting out in the trading world, it’s easy to fall prey to mistakes that can end up costing you dearly. Let me share five of the most common options slip-ups and show you what you can learn from others’ mistakes before making them yourself!
1. Make a Plan
Approaching an options trade is very different from owning a stock. Once you buy shares of a company, they will sit there as long as you’re willing to hold them. You get to call the shots.
With options, the setup is a little different. In my High Octane Trader service, we purchase options based on specific strike prices and expiration months (yes, options expire!), so it’s important not to start blindly trading just to trade. I take many factors into consideration before making a recommendation, including what’s going on with that specific company and the market in general. Options can be an unpredictable game, and gains can quickly turn into losses. Know what your goals are before trading.
2. Multiple Eggs, Multiple Baskets
In other words, don’t put all your money (or too much of it) into one single trade.
Options provide a lot of leverage, which can work for you or against you. It’s important when entering a trade (or really any investment) that you consider your risk tolerance first. Never put more money into a position than you are willing to lose.
Given their risky nature, I generally recommend that options account for no more than 5% of your total liquid portfolio. The number you allocate to each options trade can vary based on the size of your portfolio, but a general guideline would entail about 1%-3% of your 5% options portfolio in a trade.
However, you would likely need to have a minimum of $1,000 in each trade or the commission fees can start to eat into it too much. So if you had a $500,000 portfolio, $25,000 would be allocated to options and $1,000 (4%) could be managed for each trade. Although this is slightly above the 1%-3% range, at most you would lose 0.2% of capital in each trade.
This is all based on personal preference and how much risk you are willing to put into each trade. If you’re looking to minimize your losses, these guidelines should help to point you in the right direction.
3. One Contract is How Much?
This next mistake goes hand-in-hand with the last one. Don’t forget how much stock you’re controlling!
If an option is particularly cheap, it can be tempting to buy more than you normally would. But keep in mind that one option contract means that you control 100 shares of the underlying stock. For example, if you buy 20 contracts, you are actually controlling 2,000 shares of the stock. If you would normally buy 500 shares of the stock, then you should buy five option contracts.
It can be easy to see a low price and buy 50, 100 or more contracts. Even if a contract is cheap, don’t buy outside of your normal range because it can quickly end up costing you.
4. It Pays Not to Pay
Options prices can be a tricky thing. Some can seem like great bargains, but could actually be trading at a steep premium.
Overpaying for an option is not a mistake you want to make. That is why in each of my High Octane Buy Alerts, I include a buy limit. I thoroughly recommend not chasing a trade above this price. I try to leave enough room in the current price and my buy limit so my subscribers have time to get in at a good entry point. However, options move very quickly and if you miss the buy under, I know it can be tempting to go ahead and buy in at a higher price. This sets you up for more risk as volatility can send options on a see-saw. Stay disciplined and don’t chase an option too high.
5. Avoid Gambling Your Profits Away
Options can be an exciting way to make money. The leverage they offer makes 100%, 200% or even 300% winners a real possibility on a regular basis.
For some people, that means when they have a solid gain in a position (say, 50%), they are tempted to continue holding the option in hopes it will keep climbing higher.
Even if there are specific catalysts in place to support this line of thinking, it can be dangerous putting your profits at risk for a fall. Even in a low-volatility market, it can be a good strategy to take your gains when you have them. After all, it’s better to secure your money and leave some on the table rather than lose everything should an option turn against you. Also keep in mind that you can always re-enter a trade if it continues to have a clear path.
If you’re convinced the option can trend higher, one good strategy is to at least take some profits off the table while still leaving a portion of your position to take advantage of any additional upside that might remain.
I know this is a lot to keep in mind, which is why I’d love to help you navigate the trading waters and avoid these financial blunders. This is what I do every day in my High Octane Trader service, so if you’re interested in learning more about options and the best way to play them, I recommend signing up for my risk-free trial now so you don’t miss my next trade!