Options Trading Mistakes to Avoid

Options trading can be an effective strategy for investors looking to maximize profits or hedge against losses. However, it can be risky if not done correctly. In this article, we’ll go over some common options trading mistakes and how to avoid them based on lessons learned from trading over 150 options contracts. By understanding these mistakes, you can develop better strategies and become a more successful trader.

Mistake #1: Trading Out of the Money Options

One of the most common mistakes new traders make is trading out of the money options. Out of the money (OTM) options have a lower probability of success and move differently compared to the stock itself. They may be cheaper, but the likelihood of making a profit is significantly reduced.

What You Should Do Instead: Trade in the money (ITM) options. ITM options tend to behave more like the stock and have a higher probability of success. Yes, they are more expensive, but this cost is justified due to their higher likelihood of finishing in your favor. Focus on buying options with a delta of at least 0.50 or more, which indicates the probability of the option moving in line with the stock.

Mistake #2: Ignoring Liquidity and Spread

Liquidity is a crucial factor in options trading. Illiquid options and wide spreads can make it difficult to exit trades at your desired price, increasing the risk of losses. When trading options, the open interest and the spread between the bid and ask prices must be carefully considered.

How to Evaluate Liquidity:

Look for options with open interest above 1,000. Although 500-750 can be acceptable, having a higher open interest ensures easier entry and exit from trades.
Keep the spread under 10% of the option price. For instance, if an option is trading at $2.36, the spread should not exceed $0.23.

Mistake #3: Using Market Orders

Market orders fill at the current market price, which can often be unfavorable, especially for illiquid options. This mistake can cause you to buy at higher prices and sell at lower prices, resulting in unnecessary losses.

Use Limit Orders Instead: Limit orders give you control over the price at which you buy or sell an option, ensuring that you don’t overpay or undersell. The only time it’s acceptable to use a market order is when the spread is very tight, such as less than a $0.02 difference on a $2.36 option.

Mistake #4: Not Scaling In and Out of Positions

Entering and exiting your entire position all at once can increase your risk. Scaling in and out allows for better price flexibility and improves risk management.

Scaling Strategy:

Split your positions into aggressive, moderate, and conservative entries. Allocate 25% of your budget at the aggressive level, 25% at the moderate level, and 50% at the conservative level. This strategy helps ensure that if the stock does not bounce at the aggressive level, you still have capital to enter at a better price point.

Example: If you are trading with a $2,000 budget, allocate $500 at the aggressive level, $500 at the moderate level, and $1,000 at the conservative level. Each entry should have its own stop loss to limit risk.

Mistake #5: Not Having a Predefined Exit Strategy

Many traders enter a trade without knowing when and how they plan to exit. This is a dangerous practice that can turn profitable trades into losers.

Plan Your Trade: Before entering a trade, decide:

Where is your entry point?
What is your profit target?
Where will you set your stop loss if the trade moves against you?

This ensures that you are trading with a plan and not just guessing or reacting emotionally to price movements.

Bonus Tips for Successful Options Trading:

1. Avoid Overtrading: Only enter trades when there is a strong setup. If the setup does not meet your criteria, it’s better to stay out of the market.

2. Cut Losers Quickly and Let Winners Run: Use a 20-25% stop loss on options to manage risk. This gives your options enough wiggle room without exposing you to significant losses.

3. Expiration Dates Matter: Buy options with longer expiration dates to minimize time decay. If you are selling spreads, choose shorter expiration dates to benefit from rapid time decay.

4. Position Sizing: No single trade should risk your entire account. Use 1-3% of your account per trade for a more conservative approach.

Conclusion

Options trading can be a powerful tool in a trader’s arsenal when used correctly. Avoiding these common mistakes and developing a solid trading plan will help you navigate the complexities of the options market more successfully. Remember, trading is a marathon, not a sprint. Implement these strategies to stay in the game and grow your account over time.

Disclaimer:

The information provided in this article is for educational and informational purposes only and should not be construed as financial or investment advice. Always conduct your own research and consult with a licensed financial advisor before making any investment decisions. Trading and investing involve risks, including the loss of principal, and past performance does not guarantee future results. The author and publisher of this article are not responsible for any financial losses or damages incurred as a result of following the information provided.