If you are reading this article there's a good chance that you have never traded options or are just getting started. Regardless of whether you fall into one of those categories or not, this article is meant to highlight some common hazards that may be encountered by options traders to potentially help you avoid them. If you are considering options trading but you don't have a lot of experience trading stocks, I'd suggest gaining more experience with trading stocks before venturing into the world of derivatives.
Options fall into the category of derivatives because their value is "derived" from a different (underlying) asset, such as a stock, index or ETF.
However, options are sophisticated instruments and have different risks that you won't find in stocks. Therefore, education and understanding are crucial before placing your first trade or determining whether options are appropriate for you. I'm not trying to deter you from options, because they aren't necessarily riskier than stocks, it's just that you should have an understanding of how they work before engaging any options strategy. The intent of this article is to provide a better understanding of those nuances and potentially help you avoid some of the mistakes highlighted below.
Pitfall #1: Over-Leveraging
Options are leveraged products, meaning that each standard call or put is generally equal to 100 shares of the underlying stock or ETF and cost significantly less to initiate versus an equivalent stock/ETF position. When you first begin trading options, you may realize that you have additional capital to put to work that may have been tied up with equivalent stock/ETF positions in the past. Therefore, there may be a tendency to use that capital to purchase additional contracts on the same position or extend yourself into other positions that you might otherwise not have acquired due to capital constraints.
Regardless of the strategy or the number of shares you own on a given stock, you may want to consider starting with small contract positions in the beginning until you gain more experience with options. For example, if you own 500 shares of XYZ and are interested in generating some income on this position, you might consider selling only 1 or 2 covered calls against the position in the beginning and then after expiration you can determine how you want to proceed (sell the same number of contracts or more, or select another position to sell calls against, etc.).
Pitfall #2: Using Long Near-Term Calls or Puts for Speculation
When buying long options, it's not uncommon for new option traders to gravitate toward near-term call or put options because of the lower relative prices and the potential to achieve higher percentage returns. It's not that you can't trade long call and put options successfully, it's just that most new option traders don't fully understand the impact of time decay, especially for near-dated option contracts. Looking at the time decay curve below, you can see that the rate of decay generally accelerates as the option approaches its expiration date, especially for at-the-money options:
Yes, you can potentially achieve big percentage returns by buying short-dated options, but that also tends to be where the highest degree of risk occurs. If you decide to buy calls or puts in order to speculate on near-term stock movement, understand that time is working against you, so you'll typically need the stock to make a sizeable move in a relatively short period of time in order to make a profit. Therefore, if you decide to buy them you may want to consider a shorter-term mindset and be willing to take a quicker profit or loss than you might otherwise take with other options strategies. The above chart helps illustrate why many option traders prefer to sell near-dated options and take advantage of that accelerated time decay.
Pitfall #3: Altering Your Trading Strategy on a Losing Trade
This pitfall could essentially apply to any trading strategy with any financial product but it's important to highlight since options are a leveraged instrument. As you are probably aware, when it comes to trading it's important to have a willingness to admit you are wrong when a trade turns against you and exit the position to avoid additional losses.
However, since there is a financial as well as an emotional investment (i.e., pride) in every trade that you place, there can be a tendency to justify an adjustment to your original trading strategy in an effort to potentially avert a loss. This potential problem could arise in a number of forms, so keep an eye out for the following behaviors:
- Refraining from exiting the losing trade to avoid the potential regret if the stock reverses course after you close out the position.
- Doubling the contract quantity of your option position (i.e., "doubling down") in an effort to improve your break-even/profit Taking on more risk (increasing your normal contract quantity) on your next trade following a losing trade to offset the negative emotion associated with the previous loss.
- Going back to a stock that you lost money on in an effort to "get it back."
The bottom line is that all traders encounter losing trades, but those who learn how to cut losses and move on tend to have more success in the long-run.
Pitfall #4: Not Being Aware of the Strategy Trade-Off
Every option strategy provides a benefit and has a corresponding trade-off in exchange for that benefit. If you are a Schwab client and brand new to options trading, when you apply for options your account will likely be approved for options level 0, which essentially includes the income generating and/or protective options strategies: covered calls, protective puts (for stocks), cash-secured equity puts (CSEPs), and collars. Often the first trade that a new options trader places is a covered call trade, which involves selling a call against an existing stock position to generate a small amount of income on that position. This is often the most appropriate options strategy for beginners since it can help you monitor and understand how option prices fluctuate over time.
However, it's important to understand that, while the benefit of this strategy is potential income generation, the trade-off is that you sacrifice the potential upside gain on the stock beyond the strike price of the call. For example, if you sell a $65.00 strike call against your XYZ stock position for $1.00 and XYZ gaps up to $75.00 on positive news afterwards, you are obligated to sell your position at $65.00 at any time until expiration (assuming it is still trading above $65.00), and you will not profit on any of the stock price movement from $65.00 to $75.00.
Pitfall #5: Believing that the More Complex the Strategy Is, the More Profitable It Will Be
Like other investment products that are publicly traded, options are priced very efficiently. Options are listed on exchanges and allow you to take either side of the market meaning, if you believe a quoted price on a given call or put is too low or too high, you can decide to take the other side of the market and buy or sell that option, respectively. In other words, option prices are efficiently priced and reflect the known information about the underlying security.
There may be a tendency for new options traders to believe that the more sophisticated the option strategy, or the more legs the strategy has, the more likely it will be to make money, but this simply isn't the case because of that price efficiency. While each options strategy offers its own unique risk/reward characteristics, and some may be more appropriate than others based on your objective in a given circumstance, don't assume that you will have a higher probability of success if you trade the more complex strategies. Many options traders use covered calls and cash-secured equity puts and are generally satisfied sticking with those strategies. The important thing is that you find a strategy that you are familiar with (from an education standpoint), comfortable with (from an experience standpoint), and successful with most of the time (from a P/L standpoint).
- Whatever option strategy you start with, I suggest paper trading the intended strategy and tracking the results before putting real money to work.
- Always use limit orders when you place an order, which may allow you to get some price improvement from the quoted bid or ask price. However, keep in mind that limit orders could also cause you to miss the trade altogether if the price moves away from you.
- You don't have to hold any options position, long or short, until expiration. If your reason for entering the trade changes (i.e., you bought a protective put but now you no longer feel concerned about the potential downside) then consider exiting the trade to preserve capital and/or time value.
I hope that the above information helps you avoid unnecessary mistakes and perhaps trade with a little more confidence.