“Fish see the bait, but not the hook; men see the profit, but not the peril.“ -Chinese proverb
Options are both one of the greatest wealth building tools ever created and a quick way to lose all your trading capital if you over leverage and disregard the odds of your trade. Options can literally go to zero or up 1000%. They can be used to over leverage and blow up your account or can be tools for asymmetric risk management by only deploying small amounts of capital but capturing full moves in your favor. Her are what I believe are the 7 biggest pit falls new traders may encounter if they are not familiar with how options work.
- New option traders buy out-of-the-money options without fully understanding how far the odds are stacked against them. If the delta is only .10 on your option then you have less than a 1 in 10 chance of your option expiring in the money. This is not trading, this is gambling, always try to be the casino and not the gambler. There are much better odds with at-the-money and in-the-money options. Save out-of-the-money for very high probability set ups.
- Many new to options do not understand that you can not trade options on all stocks, only a few have liquid options. You need option trading volume to create liquidity so the options have a tight bid/ask spread. It is not wise to trade illiquid options because you can lose 10% or more of your capital entering and exiting your trade if the volume is not there to tighten this spread. Also look to see how much it will cost you to get in and out of the trade before trading. Option trading is hard enough with out adding the increased problem of overcoming the losses of entering and exiting illiquid options.
- Always buy an option that is in line with your trading time frame. Give your trade enough time to work. If your plan is that Apple goes to $125 in 1 month, then do not buy a weekly $125 strike call, you will run out of time and it will expire worthless. In options you have to be right about the price and time period to make money.
- It is crucial for option traders to understand the implied volatility that is priced into options above intrinsic value before earnings announcements or some other uncertain event and that the Vega premium disappears after an uncertain event comes and goes. If an at-the-money weekly Apple call options and put options are trading at $5 above intrinsic value on the day before earnings are announced the day after earnings that $5 in extrinsic value will be gone. The trade is only profitable if intrinsic value is more than $30 to replace the lost Vega value.
- Option traders must understand that to make money in out-of-the-money options they must be right about price, the time to get to the price, and if the prices rises enough to overcome the cost of theta above the strike price. However with in-the-money options you take on the risk of losing the built in intrinsic value but you only have to be right about the direction. With the right liquidity and going deep enough in the money options can be used like synthetic stocks for capturing delta but without the same level of downside risk.
- Do not risk more with options than you would while trading stocks. I advise never to risk more than 1% of trading capital on any one trade, the same applies to options. If you can only trade 100 shares of Apple in your trading account then only trade one Apple option contract in-the-money option contract. If you can trade 1000 shares of Ali Baba stock then trade 10 contracts of Ali Baba options. Do not trade to0 big with options, while they can double and triple in price they can also go to zero very quickly with a strong adverse move against your position.
- Unlike stocks that provide ownership in a company, options are derivatives that capture the moves of their underlying stocks. Options are simply contracts that will expire with the right to exercise at the strike price. They are not assets, they are bets. Options are a zero sum game, there is a winner for every loser, for every option contract bought someone wrote that contract and sold it to you. With options to be on the winning side you always want to trade with the odds in your favor, sell the deep out of the money options with little chance of being worth anything, buy the in the money options in the direction of the current market trend, sell put options under the support of the hottest stocks, sell calls on the stocks in death spirals. Avoid the temptations for fat premiums for selling puts on junk stocks and calls on monster stocks. Don’t buy lottery tickets, sell them. Don’t cap your upside on a hot stock by selling a covered call instead buy a call option and get the up side for a small investment of capital. Be on the right side of the probabilities and manage your risk and you will do very well.