While trading options can potentially bring a lot of benefits to traders, it is important that they begin with having a trading strategy in mind. In fact, diving in without a trading strategy is sure to lead to disaster. For instance, how will traders identify potential trading opportunities? What criteria will they use to determine whether a potential trade is worth going after? How much are they willing to lose on a trade that does not go according to their plan? These are important questions that each trader should have an answer to.
If a trader does not have a clearly defined options trading plan, they may wind up making random decisions based on emotions or what they have heard on the news or their peers. However, if they have a trading plan, their decisions are more likely to be based on whether an opportunity fits within the criteria they have created for themselves. Their decisions are also more likely to be data-driven and better informed.
In addition, sometimes inexperienced traders will not have an exit strategy, which can wind up causing problems in the long run. This is because options are very volatile, and they can move in either direction. Therefore, traders should know when they should exit a trade, and how long they should wait before taking action. Traders can learn more about options trading strategies by asking financial experts or even checking out tutorials from a brokerage firm, such as Saxo Bank.
Another common problem that crops up when options trading is the lack of diversification. When buying a stock, diversification usually looks like purchasing stocks in many different sectors, companies and industries. However, with regard to options, this is a little different.
With options, traders have more possibilities in comparison to buying stocks. Here, traders have to deal with both call and put options. Traders may also have many trading strategies and tactics, such as bear put spreads, married puts, and covered calls. On the whole, using multiple options strategies can help traders potentially do better even if one particular strategy is unsuccessful.
Options trading often needs an acute sense of self-control and discipline. Although options trading has the potential to offer more success when compared to investing in index funds, this does not guarantee any immediate results. As such, if a trader wants to do well in the options market, they should be willing to stick to their options trading strategy, instead of simply trading randomly or emotionally. On the whole, options trading requires traders to be smart with how they want to trade if they are looking to be successful in the long run.
Using margin to buy options
It can be tempting to use a margin loan to trade options as they may allow traders to potentially make a profit without putting up much capital upfront. However, the problem is that while a margin loan can be used to amplify any wins a trader makes, it does the same thing with losses as well. This means that buying on margin is considered risky, whether or not the trader uses it to trade options. Another concern to keep in mind is margin calls, especially if a trader is trading with leverage.
On the whole, it is essential that traders do not trade with funds they cannot afford to lose. However, trading options increase the likelihood of that happening, especially if the trader is inexperienced. Due to the heavy risk associated with buying on margin, this is generally left in the hands of highly experienced and seasoned traders.
Failing to understand technical indicators
When trading options, traders must also understand the dynamics of option pricing and how they work. For instance, there are indicators such as gamma, delta, theta, and vega that traders should regularly monitor and check. If a trader is not familiar with any of these terms or indicators, they should understand them and educate themselves before getting started with options trading.
For instance, delta represents how much the option price is expected to move based on a $1 change in the underlying asset. Basically, it tells traders the price sensitivity of the option. Similarly, theta showcases the effect that time has on a particular option. Therefore, an effective options trading strategy requires traders to know how to read charts and understand the various indicators that are available.
Not accounting for volatility
The options market is considered highly volatile. That said, smart and savvy traders can use this to their advantage, provided they are cautious and understand the risks. The expected volatility of an underlying asset influences the option’s premium, which is the price a trader pays for the options contract. As a result, understanding volatility will likely help traders determine whether an option is cheap or not. Therefore, a trader’s strategy should take into account volatility so that they know whether or not an option contract is worth purchasing.
Focusing on illiquid options
For those not in the know, liquidity determines the ease with which an asset can be converted into cash quickly. For instance, shares of stock are considered pretty liquid as they can be easily sold for cash whenever the market is open. However, trading options is not as simple as selling a stock at a given market price.
Options traders are generally at the mercy of the bid-ask spread. This is the difference between what sellers are asking for a particular asset and what buyers are willing to pay instead. If there is a large difference between the two prices, then the option is considered illiquid. This means that traders may have trouble finding a buyer when they need to, which can be a huge problem, as the options market is highly volatile with rapid price swings happening unexpectedly.
Choosing the wrong expiration
When it comes to strategies, traders are faced with having a multitude of choices when deciding on an expiration date. The good news is once a trader develops an outlook, then picking a proper expiration date typically falls into place quickly. Here are a few questions traders should ask themselves:
Is there adequate liquidity that will support the trade?
How long do I believe it will take for the trade to play out?
How do I want to hold the trade?
On the whole, options allow traders to amplify their potential gains, but they can also be risky if traders do not have any strategy or knowledge beforehand. A lack of knowledge regarding how options work can result in huge mistakes, such as not having a proper trading plan, relying too heavily on margin, or not diversifying enough. Like most financial activities, there is a learning curve when it comes to trading options, which usually requires learning by doing. So, by keeping these common mistakes in mind, traders can potentially make their options trading experience less costly.