By: Steve Smith
There is no doubt that the past few years have been challenging years from both a personal and financial perspective. And let’s just say it: those damn policymakers are to blame as well.
However, this ain’t no complaint. Time and time again, we’ve taken the steps necessary to optimize a consistent process, allowing us to meet, and find success; under any circumstance.
The Options360 Concierge Trading Service certainly faced some rough patches. But, if you look at the profit/loss equity curve, it looks surprisingly smooth.
Despite all the wild swings, Options360 Concierge Service delivered a whopping 72% gain so far in 2021; the sixth consecutive year that it returned over 48% since launching in 2014.
Behold the smooth green line.
Some fun facts include:
1. Winner (68) outpaced losers (32) by more than double.
2. Profits (average of $174 per trade more than doubled losers ($72) per trade.
I can’t make it much simpler than that!
But, I can give you 6 Rookie Mistakes You Must Avoid to put you on the path to profitability.
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Anyhow, I’ll start you off with the six rookie mistakes you must avoid.
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1. Buying “Lottery” Tickets
Too often, new traders opt for buying way out-of-the-money options as they’re attracted by their low-notional dollar amount. They perceive them as “bargains,” and a good way to gain the leverage of options. However, the low cost doesn’t mean that they’re “cheap.” In fact, out-of-the-money options usually have higher implied volatility than those closer to the money (near the underlying stock price), and are therefore relatively “expensive.”
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 option value increase. The probability that they’ll deliver a 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 that would be a possible takeover or news event that will catapult a stock higher. But, for your bread and butter trading, it’s best to stick to near-the-money strikes.
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 one is buying calls 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 is that it would be 100%. As in, the underlying stock gaps against you, and the options are left worthless.
There’s nothing wrong with making the occasional speculative bet if you understand the risk involved. But, I’d suggest you use spreads to minimize the post-earnings premium crush (PEPC) impact that occurs following the event.
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 option pricing intricacies.
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 time frame. Simply put, implied volatility provides a gauge of whether an option is relatively cheap or expensive based on past price action in the underlying stock. It’s among the most important option pricing components.
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 option prices 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 slowly moves in your direction, the option may not gain value.
However, a basic understanding of option pricing, and a grasp of a variety of trading strategies, allows 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 isn’t the idea of making 60% annually, but rather the power of consistently hitting high-probability singles instead of 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. If you do that, you’re right back where you started, but with an ulcer and heart medication.
There’s 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 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 aren’t swinging for the fences or putting far too much money into that single trade.