10 Common Mistakes of Options Trading

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by Jake Scott

While we love to focus on expanding our knowledge and terminology around trading stocks, it's also important to dive into potential mistakes an investor could make while working within the market. Below, we have a list of 10 trading mistakes per Schaeffer's Senior V.P. of Research Todd Salamone, which will help develop more clarity on what it could mean for an options trader if they fall victim to a hectic market.

1. Misallocation of Capital

When buying options, there are many opportunities to make gains of 100%, 200% and even more in short time periods, and such gains can be achieved on relatively small moves in the underlying. But depending on the types of options that you are buying, there are also chances that you can lose 100% of the dollars invested in a particular trade. So, given the risk of a total loss on a trade, but also the strong potential to double, triple, or even quadruple your money, the dollars you commit to trading options should be a significantly less dollar commitment than what you trade with stocks. By doing this, you have the potential to achieve the same profits as a stock trader, but with significantly less money at risk.

2. Thinking a High Win-rate Means Profit

Win rate, average win, and average loss are the key factors in determining bottom-line profitability when buying options. Because you pay a time premium that decays at a non-linear rate AND you have a defined period for your expected move to happen -- defined by the expiration date – option buyers should expect a below 50% win rate. Therefore, in order to achieve profits, the average win must be higher than the average loss. In other words, it is important to focus on letting profits run and cutting losses short when possible. Those with high win rates trading options tend to take profits quickly, resulting in puny winners; and they tend to hold on to losing trades, hoping they will turn into winners - a recipe for disaster. A 60% win rate with a 20% average win and 60% average loss results in a 12% loss, assuming equal dollars in each trade. Flip those numbers (40% win rate, 60% average win, 20% average loss) and a 12% profit occurs.

3. Not Diversifying Your Portfolio

In options trading, this can mean many things, including diversifying strategies to ensure you have exposure to the unknowns and different market environments. For example, strategies such as straddles allow one to profit from explosive moves in either direction; while credit spreads and other premium selling strategies allow on to profit in calm, directionless environments. But even if option-buying is your only strategy, diversity within an options portfolio implies exposure to both calls and puts, different time frames with respect to time played until expiration and more than one set up for both call and put trades. For example, calls set ups might include a momentum-based, breakout strategy and also a strategy that looks for oversold situation in which the underlying is pulling back to support.

4. Lack of Discipline

Lack of discipline can mean a number of things. Broadly speaking, whether you are an inexperienced trader that has learned from a successful trader, or an experienced trader who knows what it takes to make money, a lack of discipline means taking short cuts and consistently ignoring know rules and guidelines to achieve bottom-line success. For example, even though a key metric to successful option buying is achieving an average win that is much higher than your average loss, a trader with a lack of discipline will be quick to take profits and be negligible about cutting losses. Or, one will ignore money management principles, such as plowing significantly more money into a trade right after experiencing a losing trade because he wants to make his money back quicker or think he is “due” for a win, even though the results of previous trades are totally independent of the results of the next trade.

5. Trading Without an Edge

What is it that you know that few, if any, know? With options, this can pertain to a signal that gives you a clue on direction for a particular underlying that the masses are unaware, or something about its options – its open interest configuration or the pricing of the options - that make the risk-reward attractive now versus other times. When trading, you are embarking on a journey with many others that are trying to accomplish the same thing, and some are taking a view that directly opposes you. Like anything in which competition is involved, those with an edge have a leg up.

6. Front-running Drivers

It is natural for anyone speculating in the market to want action all the time. But beware, especially when buying options, you have a defined time in which the stock has to move and in most cases, there is a time premium embedded in the option’s price that decays at a non-linear rate over time. As such, it is not a good idea to front-run drivers, as these factors work against you, and thus more precision is needed than a stock buying strategy. Remember, there is a big difference between buying a stock and buying an option. While options give you the advantage of reduced dollars at risk and leverage relative to buying an equity, there are risks you take on in exchange for these benefits. The smart option buyer recognizes these risks and works to reduce them through patience and an understanding of the “Greeks,” or the various factors that determine an options price.

7. Buying What’s Cheapest Without Understanding the Greeks

Some are drawn to options because they are cheap. You can buy a 10 cent option, which typically controls 100 shares of the underlying equity or exchange-traded fund, for $10 (0.10 x 100 shares). And this might look “cheap” relative to a $4.00 option, which costs you $400 ($4.00 x 100). The 10 cents option could be on the ones that deliver 1,000 percent returns, but the chances are slim. You have to look at the delta, which is an approximation of the option being worth anything at expiration, since the delta is a measure of the sensitivity to the underlying’s price. It is the nickel and dime options that usually have a 90% or more probability of being worthless at expiration. If such options make up the core of your option-buying strategy, you run a high risk of losing your entire trading capital devoted to options. In other words, cheaper is not necessarily better.

8. Poor Options Selection

There are a myriad of routes available when trading options, including the many strike prices available and the expiration played. The upside of this is the flexibility and ability to fit the time frame with the indicator(s) you are using, the downside is that this can be intimidating and overwhelming to the inexperienced options trader. One focus when buying options should be tied to your risk tolerance, as some options can produce higher returns than others, but with that comes the higher probability of losing your entire investment. This is often when strike selection becomes important when you lock into a specific time frame. Speaking of time frame, the expiration you select is also important, and as such, aligning your time frame with your indicators is critical when trading options.

9. Trading Illiquid Options

If you are an individual trader, beware of the difference between the bid price (the price at which you can sell an option) and the ask price (the price at which you can buy the option). This is known as the spread. The more liquid options will have narrower bid and ask price, such as a nickel or dime difference. The most liquid options will have a penny difference on some contracts. The average daily volume of a contract and its open interest can also be indicators of liquidity, although sometimes the open interest may be attributable to only one day or two days of trading during the contract’s life, depending on the situation.

If you are consistently trading illiquid contracts with wider spreads -- selling the bid and buying the offer -- you are incurring significant slippage. In such situations, work the order by placing limit orders between the bid and ask to see at what point they’ll fill the order. If they don’t fill it, cancel the order and try again. Keep in mind that in the more liquid situations where there is decent volume and a narrow spread, there is a chance that you can buy an option at the bid, or sell at its ask. Over time, this can give you an advantage.

10. Focusing on Singular Time Frames

This applies to reaching charts. Sometimes traders get fixated on intraday or daily charts, and have zero perspective on resistance or support levels or longer-term moving averages that may lie just overhead or below that could impact the price action. So, even if you are playing a shorter-dated option, such longer-term levels could impact the short-term price action. As an option trader, such awareness is critical in appropriately defining the risk-reward in a trade. If such a situation arises, it may cause you to pass on the trade, or decide to play an option with a longer time til expiration to give it time to break through the support or resistance that was not visible on a shorter-term chart.