By: Steve Smith
Buying “Lottery” Tickets
Too often, new traders opt for buying way out-of-the-money options because of attracted to their low notional dollar amount. They perceive them as a “bargain” and a good way to gain options’ leverage. However, the low cost doesn’t mean that they come “cheap”. In fact, out-of-the-money options usually have higher implied volatility than those closer to the money (near the underlying stock price) — relatively speaking, they’re “expensive.”
Out-of-the-money options also come with a significantly lower delta. This means that 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’ll profit diminishes the further out-of-the-money that you go. Remember, something like 80% of all options expire worthless.
Once in a while, it’s OK to make a calculated-risky bet. An example of this would be a takeover or news event that’ll catapult a stock higher. But, for your bread-and-butter trading, it’s best to stick to near-the-money strikes.
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 strategy would be buying call or put options ahead of an earnings number in the hopes of hitting a home run. The upside in 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 gapping against you. This means that the options are left worthless.
There is nothing wrong with occasionally making a speculative bet if you understand the risk involved. However, I’d suggest you utilize spreads to minimize the post-earnings premium crush (PEPC) impact that happens after the event, which brings us to rookie mistake #3.
Failing to Understand Implied Volatility
Being wrong on a stock’s direction is 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 accounting for implied volatility; a measure of the expectation or probability of a given size move within a given time frame. Simply put, implied volatility provides a gauge as to whether an option is relatively cheap or expensive — based on past price action in the underlying stock. It’s among the most important components in option pricing.
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Therefore, in order to consistently make money trading options, one must attain a basic understanding of implied volatility.
Failing to Understand Time Decay
Traders also commonly fail to realize that options are a wasting asset. One very important component in the option price 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.
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 (SPY). Stretch that monthly gain from 2% to 4%, and the annualized profit is on the order of 60%.
The important takeaway here isn’t 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. However, with an ulcer and heart medication.
There’s plenty of room for speculation with options, but to stay ahead of the game, you must pick your spots wisely.
Failing to Diversify
Ideally, no single position should represent more than 5% of a portfolio. My personal options account typically carries six to 10 positions at a time. These can run from complex, multi-strike hedged positions with four to six months until expiration, to speculative plays based on unusual activity or an upcoming event that’ll 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 swung for the fences and put far too much money into that single trade.