By: Steve Smith
Options360 has been bobbing and weaving, locking in gains, pushing our performance up to 22.1% year to date. I still fully expect to finish 2022 with a 50%+ return. But don’t mistake my confidence for rashness; risk management will always be first and foremost.
This means sticking to my knitting and applying the basic lessons I’ve learned over my 30-year trading career. It may seem simple in theory, but it takes discipline to maintain in practice.
Here are five rookie trading mistakes I continually discuss with Options360 members through daily alerts and our weekly webinar calls.
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 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 risky bet if it’s a calculated one, such as there might be a takeover or 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 (close to the underlying price).
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 calls or put options ahead of an earnings report in the hopes of hitting a home run. The upside to being right about such an unpredictable event is a big, fat profit.
But the downside when you’re wrong?
It could be 100% overnight. As in, the underlying stock gaps against you, and the options you paid for 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 Rookie Mistake No. 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. And that’s failing to understand the intricacies of option pricing.
One of the biggest mistakes new options traders make is not accounting for implied volatility, which is a measure of the expectation or probability of a given 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. It is among the most important components in option pricing.
Therefore, in order to consistently make money trading options, one must have a basic understanding of implied volatility.
4) Failing To Understand Time Decay (Theta)
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. As time goes on, the value of that option decays, which has 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 use it to your advantage.
5) Ignoring The Power Of Compounding Small Gains
Above, we referenced the risks of swinging for the fences. The less-sexy — but far more lucrative — reality is that the best options traders grind out steady profits using a wide variety of strategies. Instead of looking for “home runs,” these successful traders aim 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.
If you make any of the above mistakes, I would love the opportunity to help you avoid them in the future. We are a community of like-minded individuals who all have the same goal in mind — a more prosperous future. Learn firsthand how options trading doesn’t have to be risky and can set you on this path to financial freedom today with the rest of the Options360 family! — just click here to join!
Looking forward to trading with you!
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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