5 Mistakes To Avoid During Option Trading

Option trading is popular among traders as it helps them earn a good amount of trading profits. It helps in earning profits when the prices of stocks move up, down, or sideways. The added advantage which options trading offers is that it can be conducted with a relatively lower amount of cash reserves.

But, there is a catch when talking about options trading.

Though it seems to be a simple yet profit-making process, it can also result in traders losing more than they earn and even beyond the amount of money that was initially invested by them. Moreover, this loss can take place in a short span of time, and hence traders and investors opting for options trading need to be cautious while proceeding further.

Before finding out the mistakes that even confident traders make when trading in options, let us first, in brief, understand what options are?

What are the options?

Options fall under the categories of derivatives. Since they are a type of derivatives, options are securities that derive their value from the underlying assets. These underlying assets can either be stocks, commodities, currencies, or indexes, or even any other financial security.

An option contract is a financial contract where the investor has the right either to buy or sell an asset at a pre-determined price on a specific date. It offers the right to buy but definitely not an obligation to do so.

Options contracts are broadly classified as call options and put options.

Mistakes to avoid while trading in options

Here are the top 10 mistakes which the beginner options traders end up making while indulging in options trading. Learning about these mistakes will also help you trade smarter by preventing you from taking wrong actions.

1. Don’t forget to make an exit plan: The first and foremost rule in options trading, just like stock trading, is to control your emotions. Trading in options without having an exit plan can cause you significant losses. Even though options trading seems profitable in the initial stages, it can cause you more loss if you continue to stay in the trade for a longer duration. Hence, you need to have an exit plan for both situations i.e., when you are earning profits and even when you suffer a loss.

In order to trade smarter, have an exit plan irrespective of the fact that whether you are buying or selling options. By having a proper exit plan in place you are able to establish a more successful options trading pattern. Have an upside as well as a downside exit plan in place. When you reach the upside positions set by you exit the trade taking your profits. Clear the position if you reach the downside stop-loss.

2. Purchasing OTM (Out of the Money) Options: Traders, especially those who are new to options trading, end up buying out of the money options. These options are usually cheaper and also popular among traders. The key here that the traders should keep in mind is that the value of the option purchased will decline and hence the option of the contract might either move up or down before the options expiration date. If there is a favorable movement then you can regain the purchasing cost of your options. Though the OTM options are profitable, the profits earned are not consistent. Hence they are not suitable for a volatile market.
3. Making up for losses by doubling up: There are times when the trade goes opposite of what we expected it to be. In such cases, we tend to forget the trading rules set by us and continue trading with the same option we started our trade with. You must remember that doubling up to catch up rule does not work in option trading. To avoid this mistake and trade smart close the trade when you face losses and look for other opportunities for earning the desired returns.
4. Overleveraging your option trades: As a beginner to option trading, it is a common mistake to misuse the leverage that is offered by the options contracts. While doing so, traders often neglect the risk factor that is involved in options trading and end up paying attention only to the low cost of options contracts. In order to prevent losses from options trading, understand the leverage well beforehand. The thumb rule is to stick with one options contract in the beginning if you trade in 100 shares lot. This is also considered to be as a good testing amount. In case you fail to get success in these lot sizes, chances are that you hardly will be successful with bigger lot sizes while doing options trading.
5. Don’t be resistant to new strategies: It is often seen that traders opting for options trading, in the beginning, are resilient towards learning new option trading strategies. For instance, many of the option traders say they will either never buy out-of-the-money options or will never sell their in-the-money options. This strategy is absolutely wrong. The best way to prevent losses when indulging in option trading is to understand that options are derivatives. Their prices do not move the same as that of the underlying stocks. Hence, it is essential for traders to be open to learning new option trading strategies. They should learn to cut the trade in order to cut their losses and start finding a different opportunity to make the required profits.

Bottom Line

Trading in options can be one of the easiest ways to become wealthy but that happens only when the traders are able to abide by the basic rules of options trading. As mentioned earlier, options contracts can cause more losses than they generate profits and hence should be a part of the diversified portfolio. Avoid making the above-mentioned mistakes so that you don’t end up being trapped in trades that constantly cause losses.

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