For beginning options traders here are some common pitfalls you need to avoid if you want to make money trading options.
1. Making Big Bets Speculating on Earnings Announcements
When most people think of trading options, they think of ultra-risky strategies. Probably the most speculative is the bet on an earnings announcement, usually looking for a “Grand Slam”.
Now it is possible to make big money on this type of bet BUT it is usually the exception as you will normally need a HUGE move in the underlying stock to hit a “Homerun” and here’s why: Options are priced for the earnings volatility(see rule #2), so most people underestimate the move needed for the option to gain enough value to make any money.
So if the stock moves a little you lose, it the stock doesn’t move at all or worse you guess wrong you lose. So you have a 75% of losing a 100% of your money and even if your right, its not a guarantee that you will make money.
So does this mean we should never speculate on an earnings play? Well no because sometimes the rewards can be worth the risk but you just need to know the odds are against it and place your bets accordingly. Keep them a very small percentage of your account.
2. Not Understanding Implied Volatility
Being wrong on a stock’s direction is the easiest way to lose money. It’s not the only way though, there’s a second, and perhaps even more frustrating way to lose money with options. That is, not understanding how options are priced.
Probably the biggest mistake that a new options traders will make is not accounting for implied volatility, which is a measure of the expectation or probability of a given size move within a given time frame.
In simple terms, implied volatility gives you a gauge as to whether an option is cheap or expensive based on the stocks past price action and it is the most important component in option pricing.
Many traders say “options don’t work” and that’s because they bought puts or calls ahead of earnings, they were right on the direction of the stock after the earnings announcement but the option price hardly changed and this is because the implied volatility declined dramatically post-earnings.
So in order to consistently make money trading options, you MUST learn a basic understanding of implied volatility.
3. Not Understanding Time Decay
Many traders don’t realize that options are a wasting asset. This is the other BIG component in the price of an option. And that is the time until expiration. As time approaches the expiration date, the value of the option declines.
If you are buying calls or puts outright, and the underlying stock moves in your direction at a slow pace, the option may lose value or not gain enough in value to offset the time decay.
You need a basic understanding of option pricing and a good grasp of trading strategies to allow you to offset the impact of time decay or even turn it to your advantage.
4. Not understanding Compounding of Consistent Small Gains
In Rule #1, I covered the risk of swinging for the fences with options. Less “sexy” but far more lucrative is that the best options traders take steady profits out of the markets using a wide variety of strategies. They are looking for consistent gains of 2% to 4% a month, with an occasional kicker from some speculative bets.
Now, 2% a month may not sound like a lot, BUT compounded over a year, it comes out to 27%. And that’s more than three times the average historical return of the S&P 500. Increase that monthly gain to 4%, and you’re looking at an annual profit is around 60%!!!
What’s important here is not making 60% in a year, but rather the power of consistently hitting singles rather than swinging for the low-probability home runs every time we step up to the plate.
Taking excessive risks may mean that you’re up 100% one month then down 50% the next. If you do that you’re right back where you started, but stressed out and on an anti-depressant.
There is nothing wrong with speculation with options, but you have to pick your spots wisely.
5. Not Diversifying
In practice no single position should be more than 5% of your account. My portfolio will typically have at least six to 10 positions at any one time. These can run from complex multi-strike positions that have 4 to 6 months until expiration, to a few highly speculative bets based on some unusual activity or an upcoming event that will be held for just a few days.
Why do I do this? Because I never want to get knocked out by any one trade.
If someone blows out their account trading options, it’s almost always because they not only swung for the fences on earnings plays, but they were risking too much of their account on each trade.
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– Robert Walsh