New option traders can make many mistakes when they first start trading options. Here is a quick list on what to do and what not to do as you come into the options market for the first time.
Are Options Good for Beginners?
“Fish see the bait, but not the hook; men see the profit, but not the peril.” – Chinese proverb
Options can be both a great wealth building tool or a quick way to lose all your trading capital if you over leverage your trades. Disregarding the odds of your option trade being a winner can lead to outsized bets that lead to zero dollars in your account.
Option contracts can go to zero by the expiration date or up 100% right after entry. Option traders must always manage for both possibilities based on an options probabilities of movement by expiration. The Delta of an option is a good probability indicator, it is part of the option pricing model.
An at-the-money option will have approximately a .50 Delta as it can move equaling in-the-money in either direction. A deep-in-the-money option will have nearly a 1.00 Delta as its prices moves with the stock price dollar for dollar. An option far-out-of the money can have a .10 Delta if it has approximately a 10% chance to go in-the-money by expiration. Delta for an option contract can approximate the odds for new option traders and help them choose their position size carefully.
Options can be used to overleverage and blow up your account with big all or nothing bets. Or they can be tools for asymmetric risk management by only deploying small amounts of capital but capturing full moves in your favor.
Options are also tools professional use to hedge their stock positions to limit their downside losses. Here are what I believe are the seven biggest mistakes new option traders may make if they are not familiar with how options work.
What should you not do when trading options?
Too many times new option traders become obsessed with buying far out-of-the-money options without fully understanding how far the odds are stacked against them. They become gamblers looking to play the lottery. If the Delta is only .10 or on your option then you have less than a 1 in 10 chance of your option expiring in-the-money.
Even if you get a move in your favor your far out-of-the-money option will not increase in value until the Delta expands enough to overcome the time decay. It takes a huge move in price to increase the value of out-of-the-money options. The odds of it expiring in-the-money have to increase enough to drive up the contract price.
New option traders can become frustrated when price moves in their favor and their out-of-the option goes down in value! The delta must expand faster than the time value decays. Options with at least a .25 Delta will double your odds of success a lot from a 1 in ten chance of profit on expiration to a 1 in 4 chance of being able to go in-the-money and grow quickly in price as the delta expands more easily with a move in your favor.
Also, an option trader doesn’t have to wait to expiration, an option can be sold to lock in profits at any time in its life span. Most of the time it is better to lock in option profits why they are there and not get greedy for more gains. Option contracts are deteriorating assets and time is not on the side of the option buyer.
Many new to options don’t understand that you can not trade options in all stocks, you need open option volume to create liquidity so the options have a tight bid/ask spread. It’s not wise to trade illiquid options because you can lose 10% or more of your capital in a position just in the entry and exit of your trade. If the volume is not there to tighten this spread executing option trades can be expensive.
Look to see how much it will cost you to get in and out of an option trade before trading any option chain. You want to see option spreads of a dime to fifty cents at most preferably. A dime bid/ask spread on an option will cost you $10 to get into the trade and then $10 to get out. A 100 share contract times .10 cents a share equals $10 each way. This is $20 round trip in addition to your commission fee and this is only for one contract.
A $1 bid/ask spread will cost you $100 in slippage to get in and then $100 or more to get out of one contract. This is a trading expense that compounds over time, the moment you enter a one contract option with a $1 bid/ask spread you are already down $100 with the slippage. Only trade in the most liquid option contracts on the leading stocks and stay away from the low volume markets that will slowly eat away at your trading capital through slippage.
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 $200 in 1 month, don’t buy a weekly $200 strike call, you’ll run out of time and it will expire worthless. Buy at least a monthly out call option that will not expire before your trade has the time to play out. In options you have to be right about the price and time frame, just one or the other is not good enough for profitability. You can be right about the price but run out of time on your option or you can be right about the move but buy an option too far-out-of-the-money or too expensive to profit from the move.
It’s crucial for option traders to understand the implied volatility that is priced into options above the normal time value before earnings announcements or some other uncertain news event and that the Vega premium is priced out of an option after an uncertain event is over.
If an at-the-money weekly Apple call option and put option are trading at $10 above normal time value on the day before earnings are announced the day after earnings that $10 in Vega value will be priced out of the option contract. The option trade is only profitable if the intrinsic value of the option going in-the-money of the strike price chosen is more than $10 to replace the lost Vega value.
When trading through a volatile event like earnings you must be right about the magnitude of the price move to be profitable, the direction alone is not enough. You will see that buying options through earnings has a low probability success rate because the option sellers give themselves plenty of Vega value to cover their risk of selling options through earnings. It’s very difficult to overcome this Vega collapse. Many will tout the few times the move was not priced in but that is a low probability event. Short straddles can be more profitable through earnings than one sided long option bets on direction due to volatility crush.
With in-the-money options you take on the risk of intrinsic value but you only have to be right about the direction. In-the-money options have little Theta or Vega value they are almost all intrinsic value and have very high deltas over .90 and with the right liquidity and going with deep-in-the-money options can be used like one-sided synthetic long stock positions but without the same level of downside risk. Deep-in-the-money option positions also require less capital to hold the same leverage a stock position allows.
Don’t risk more with options than you would while trading stocks. Never to risk more than 1% of total trading capital on any one option trade. If you can only trade 100 shares of Apple in your trading account then only trade 1 Apple in-the-money option contract. If you’re trading capital is large enough to handle trading 1000 shares of a stock in your normal stock trading account then trade 10 contracts of those options.
Don’t trade to0 big with options, while they can double and triple in price they can also go to zero. Options can move so fast that they are difficult to have stop losses on the option price itself. It’s much easier as an option trader to simply have option trades be all or nothing trades with small positions in most cases. A 50% stop loss on an option is the best you will likely be able to manage a lot of the time with most option plays. Stop losses have to be on the chart of a stock where they have meaning at a technical level and not at a random option price decline level. This is why I prefer all or nothing option trades and using the stock price.
Unlike stocks that are ownership in a company, options are derivatives of stocks and simply contracts that will expire. They are not assets, they are bets. Options are a zero sum game, there is a winner for every loser in the option market. For every option contract bought someone wrote that contract. While trading with options to be on the winning side you always want to trade with the odds in your favor. If you are a seller of premium sell the out-of-the-money options that have little chance of being worth anything.
Option buyers can buy to open the in-the-money options in the direction of the current market trend. Option premium sellers can sell to open put options under the support of the hottest stocks during bull markets and sell calls on the stocks in downtrends. Avoid the temptations for big premiums for selling puts on volatile stocks and calls on growth stocks in strong trends, that can be dangerous.
With options don’t buy low probability far out-of-the-money 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 position size of capital. Be on the right side of the probabilities and manage your risk and you will do very well over the long term if you have an option strategy with an edge.
Approach your option trading like a casino operator not a gambler. Set bet size limits for yourself. Understand and respect the odds of success on any trade and manage your maximum risk exposure of every option trade carefully.
Don’t try to get rich quick your first priority is to conserve the capital in your option trading account with small bets. When you start trading options strive to make small mistakes in your trading not large mistakes. There is always someone on the other side of your option trade so trade carefully, it’s not easy money it’s a game that you have to play better than other traders.
11 Options Trading Tips
1. Short options have theoretically unlimited risk when they are unhedged.
An unhedged short option contract has the reward limited to the price the contract was sold at but price can go to any level creating unlimited risk exposure if it doesn’t have a hedge or stop loss set at a buy to close level. It can be very dangerous to hold a short option contract with no hedge in place as it is unlimited risk. Professional option traders almost always hedge short options with a cheaper long option contract or the underlying stock.
2. Theoretical option trading are not the same as trading with real capital at risk.
Learning about option Greeks and option plays and trading them with real money at risk are very different experiences due to ego and emotions. Research, study, and simulations don’t contain the element of risk and uncertainty that the potential for losing real capital does.
Be prepared psychologically for the stress, emotions, and ego that you’ll experience with capital at risk, don’t let the rush of feelings take you by surprise. Start with small position sizes and work your way up to more size over time. Be ready to manage your mind, emotions, and thoughts in the option market.
3. Trade your option strategies consistently but adjust to the price action.
Trade your system based on your own parameters and signals but don’t blindly take the same types of risks in all market environments and on all charts. The current directional market trend of price action and the level of volatility and adjust position size and directional bias to stay with the profitable path of least resistance on the chart.
Not all market environments are suitable for all types of option plays. Know the difference.
4. Liquidity is the first fundamental filter for options trading.
Only trade options with highest volume of interest so you don’t lose a large percent of your capital on the bid/ask spread when entering and exiting trades. You must trade on the option chains that have the liquidity to trade with spreads measured in cents and not dollars. A $1 price difference in the bid/ask spread will cost your $100 to get in and out of a trade in addition to commissions.
The best liquidity is in the front month at-the-money options, and option chains get more illiquid as they go deeper in-the-money or out-of-the-money. The moneyness must be considered in a winning trade because you might have to roll the option to a more liquid contract. Also the farther out in time to expiration you trade the less liquid options become with wider bid/ask spreads. Most options chains can’t be traded due to the fact that they are just simply not liquid enough.
Stay with only the leading stocks with the most liquid option chains, it’s easier for getting in and getting out and avoiding all the costs in the spreads.
5. Don’t let a losing option trade get out of control.
Define your risk in every option play before you enter it whether long or short. Set limits for risk of capital as well as delta, gamma, and theta exposure. Regardless of the option play manage the risk exposure by exiting long option positions, moving hedges, rolling options out in time or strike, or closing option legs. Always be aware of the current risk/reward ratio in a current option play and exit it when the real risk is no longer worth the potential reward.
6. Know how to lose quicker on an option trade.
A losing option trade should have the loss capped to the hedge or the stop loss level on the stock chart. An option trader should never lose more than 1% of their total trading capital on one option play. Most long option trades should have a position size between 1% and 2% of total trading capital at most.
The stock chart is more meaningful than the option price to have a technical price level that is meaningful. Long option risk must be managed primarily in the position size as options can go to zero. Don’t trade too big or let a losing trade get out of hand, know where you are getting out before you get in.
7. Diversify your watchlist of stocks, types of signals, and option plays.
An option trader needs a diversified watchlist of option chains to trade with different types of plays to choose from based on the current market range and trend. The more types of trading edges with options you have to execute the greater your odds of success through different types of market environments. Multiply opportunities with multiple edges based on math and probabilities.
8. Keep your option trades as simple as needed.
An option trader doesn’t need to create complex 4-legged option trades to make money. A trader only needs a repeatable edge to profit from the options market. Complexity can add risk and unnecessary trading activity. All that matters with options trading is probability, volatility, repeatability, profitability, and the quantified risk/reward ratio. Profitable options trading can be simple. The edge is all that matters. Your wins just need to be larger than your losses on average or you need a high win rate with small losses.
9. Patience can be an option sellers edge but an option buyers weak spot.
An option seller has the benefit of time as theta decays continually and they can let the clock pay them in time on the option buyer if the move is not in the buyers favor. The option buyer doesn’t have the luxury of time as they must be right about the direction of a price move and also the magnitude of the price move along with the time frame in which it will occur. Time is the option sellers friend but the option buyers enemy. The direction and momentum of the price trend determines who the pressure is on until expiration.
10. Anything can happen in the markets at any time.
Always accept anything is possible in the markets at any time. Don’t think something has to happen or a market can’t go any higher or lower after a long trend in one direction. Think in probabilities and possibilities not certainties and strong convictions. Option traders must stay open-minded to all potential outcomes and accept reality as it plays out.
11. Never expose yourself to the sudden risk of ruin with too much open-ended and unhedged short options.
One big risk event can wipe out all your gains at one time. Hedges are cheap insurance against ruin. Always manage risk through proper position sizing with long options and proper hedges and stop losses with short options.
Many option traders have been ruined when what they thought was impossible happened, some examples are the Lehman bankruptcy of 2008, September 11, 2001, and Black Monday 1987. Option traders were ruined on these dates when they did not hedge their short option risk or were simply overexposed with long options positions.
The best option traders are more like mathematicians and statisticians than emotional gamblers.