Investopedia defines options as “contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date.” They are used as a hedge for managing the risk caused by market fluctuations. Trading options can be lucrative, but risky. If you are a beginner, you should watch out for these common mistakes to make the best of your trades.
Not Having a Plan A
Trading options requires a sound strategy. You have a limited time in which you can profit from the transaction. If you miss the opportune moment, you may lose lot of money. Figure out how much you are willing to risk and test out your plan with paper trades before getting out in the real world.
Not Having a Plan B
What happens if your plan A doesn’t work out? You need to decide in advance on the amount of profit that will make you satisfied, as well as on how much you can stand to lose. Always consider worst-case scenarios.
Neglecting the Expiration Date
The expiration date is the most important factor when deciding to buy an option. Essentially, if you want to profit from an option, you need to predict not only which way a stock will go, but also how long it will take for it to reach that price. Your chances are best if you have an inside information about something that could impact the stock value. But if you don’t pay attention to the dates, your option may expire before the anticipated event, rendering your trading plan worthless.
Investing Too Much Money
You don’t need to invest too much money to profit from options. Options are significantly cheaper than stocks, but that is because they are riskier. When investing in options, don’t risk more than 5% of your total portfolio per trade.
Buying Cheap Options
Beginners should avoid investing in cheap options. They are less likely to make you any money, since they require a drastic change in the market to occur. When determining the price of an option, whether it is expensive or cheap, pay attention to implied volatility.
Being Unprepared for Early Assigned Options
As an option seller, you need to be prepared for a situation where an investor exercises their right early, especially if you sell a put. Always set aside an emergency fund in case you need to cover the transaction costs sooner than you expected.
Buying Illiquid Options
Liquidity is important because it allows you to trade in or out of options quickly, thus making it easier to cut your losses. To make sure you are buying liquid options, pay attention to open interest and volume.