“Fish see the bait, but not the hook; men see the profit, but not the peril.”
-Chinese proverb
Options are both one of the greatest wealth building tools ever created and a quick way to lose all your trading capital if you over leverage and disregard the odds of your trade being a winner. Options can literally go to zero or up 1000% you have to always manage for both possibilities. They can be used to over leverage and blow up your account or can be tools for asymmetric risk management by only deploying small amounts of capital but capturing full moves in your favor. Here are what I believe are the 7 biggest pit falls new option traders may encounter if they are not familiar with how options work.
- New option traders buy far out-of-the-money options without fully understanding how far the odds are stacked against them. 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 very frustrated when price moves in their favor and their out-of-the option goes down in value! In most instances this is not trading, this is gambling, always try to be the casino and not the gambler. Options with at least a .25 Delta will increase your odds of success a great deal to 1 in 4 being able to go in-the-money and grow quickly in price as the delta expands more easily with a move in your favor.
- Many new to options do not understand that you can not trade options in all stocks, you need option trading volume to create liquidity so the options have a tight bid/ask spread. It is not wise to trade illiquid options because you can lose 10% or more of your capital at risk entering and exiting your trade if the volume is not there to tighten this spread. Look to see how much it will cost you to get in and out of the trade before trading. You want to see option spreads of a dime to fifty cents 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 an operating expense that adds up over time, the moment you enter a one contract option with a $1 bid/ask spread you are already down $100 with the slippage. I strongly advise you to only trade in the most liquid option contracts you can find and stay away from the low volume markets that will slowly eat away at your trading capital.
- 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 $110 in 2 months, then do not buy a weekly $110 strike call, you will run out of time and it will expire worthless. Buy a two month out call option that will not expire before your trade has time to work out. In options you have to be right about the price and time period just one or the other is not good enough for profitability.
- This is another crucial reminder that I think is so important. It is 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 event and that the Vega premium disappears after an uncertain event comes and goes. 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 gone. The trade is only profitable if 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 have to 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 is 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.
- There are two different ways to use options to capture a simple price move. Option traders must understand that to make money in out-of-the-money options they must be right about price, the time to get to the price, the magnitude of the price move, and if the price rises enough to overcome the cost of Theta and Vega above the strike price. However 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 deep enough in-the-money options can be used like synthetic stocks but without the same level of downside risk.
- Do not risk more with options than you would while trading stocks. I advise never to risk more than 1% of trading capital on any one trade, the same applies to options. 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 r trading capital is largest enough to handle trading 1000 shares or Twitter in your normal stock trading account then trade 10 contracts of Twitter options. Do not trade to0 big with options, while they can double and triple in price they can also go to zero. Never risk more than 1% of your total trading account on any one option trade. Less is even better. Options can move so fast that they are difficult to have stop losses with. It is much easier as an option trader to simply have option trades be all or nothing trades with very 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 weekly options. Stop losses have to be on the chart of a stock where they have value not at a random option price decline level. This is why I prefer all or noting option trades.
- 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, 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 deep 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 down trends. Avoid the temptations for fat premiums for selling puts on junk stocks and calls on monster 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 investment of capital. Be on the right side of the probabilities and manage your risk and you will do very well over the long term.
Approach your option trading like a casino operator not a gambler. Set bet size limits for yourself. Understand and respect the odds of success and the maximum risk exposure of every option trade of place. Try to 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 is not easy money it is game that you have to play better than other traders.