As shoppers have become increasingly savvy in finding online bargains and discounts, we see similar behavior spilling into other aspects of their lives. This includes investment advice and stocks they seek. But sometimes, it’s better to pay up to get a little better quality. This is particularly true with options. Which brings us to the first of our rookie mistakes.
1. Buying “Lottery” Tickets
Too often, new traders opt for buying way out-of-the money options, as they are attracted by their low, notional dollar amount. They perceive them as “bargains” and a good way to gain the leverage of options. But the low cost doesn’t mean they are “cheap”. In fact, out-of-the money options usually have a higher implied volatility than those closer to the money (near the underlying stock price) and are therefore, “expensive’ in relative terms.
Out of the money options also come with a much lower delta; meaning, it will take a much larger price move in the underlying shares to cause an increase in the value of the option. The probability that they will deliver a profit diminishes the further out-of-the-money you go. Remember, something like 80% of all options expire worthless.
Once in a while, it’s OK to make a calculated risk bet, such as there might be a takeover; or, maybe there is a news event that will catapult a stock higher. But for your bread and butter trading, it’s best to stick to strikes that are near-the-money.
2. Swinging for the Fences Ahead of Earnings. When people talk about trading options, the conversation usually turns to ultra-risky strategies. By far, the most common of these is buying call or put options ahead of an earnings number. Most people do this in the hopes of hitting a home run.
The upside of being right about such an unpredictable event is a big fat profit.The downside when you’re wrong? That’d be 100%. As in, the underlying stock gaps against you, the options are left worthless.
There is nothing wrong with making the occasional speculative bet if you understand the risk involved. But I’d suggest you use spreads to minimize the impact of the post earnings premium crush (PEPC) that occurs following the event. Which brings us to #3.
3. Failing to Understand Implied Volatility. Being wrong on a stock’s direction is clearly an easy way to lose money. But there’s a second, and perhaps even more frustrating way to lose money with options: failing to understand the intricacies of option pricing.One of the biggest mistakes new options traders make is not taking into account implied volatility, which is a measure of the expectation or probability of a given size move within a given time frame.
Put simply, implied volatility provides a gauge as to whether an option is relatively cheap or expensive based on past price action in the underlying stock, and it is among the most important components in option pricing.
Therefore, in order to consistently make money trading options, one must attain a basic understanding of implied volatility.
4. Failing to Understand Time Decay. Traders also commonly fail to realize that options are a wasting asset. One very important component in the price of an option is the time until expiration. So as time goes on, the value of that time decays, with a negative impact on the overall value of the option itself.
If you buy calls or puts outright, and the underlying stock moves in your direction at a slow pace, the option may not gain in value. However, a basic understanding of option pricing and a grasp of a variety of trading strategies will allow you to offset the impact of time decay — or even turn it to your advantage.
5. Ignoring the Power of Compounding Small Gains. Above, we referenced the risk in swinging for the fences with options. The less-sexy – but far more lucrative – reality is that the best options traders grind out steady profits using a wide variety of strategies, looking to consistently earn 2% to 4% a month, with an occasional kicker from speculative bets.
Two percent per month doesn’t sound like a lot, but compounded over a year, it adds up to 27%. That’s more than three times the average historical return for the S&P 500. Stretch that monthly gain from 2% to 4%, and the annualized profit is on the order of 60%
The important takeaway here is not the idea of making 60% in a year, but rather the power of consistently hitting high-probability singles rather than swinging for low-probability home runs every time we step up to the plate.
Extreme risk-taking could mean that you’re up 100% one month — and down 50% the next. You do that and you’re right back where you started, but with an ulcer and heart medication.
There is plenty of room for speculation with options, but to stay ahead of the game, you have to pick your spots wisely.
6. Failing to Diversify. Ideally, no single position should represent more than 5% of a portfolio. My $20k Portfolio typically carries six to 10 positions at a time. These can run from complex, multi-strike hedged positions that have four to six months until expiration, to speculative plays based on unusual activity or an upcoming event that will be held for just a few days.
Why? Because again, I never want to get knocked out of the game on one trade, or allow a position to get so large that it could threaten gains elsewhere in the portfolio if things go south.
When people go broke trading options, it’s usually because they not only swung for the fences, but they put far too much money into that single trade.
Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.