Option Rookies: 3 Errors to Avoid

Earn Money by Avoiding Losing Ideas

Errors to Avoid
Mistakes to Avoid. pixabay.com

Brand new option traders tend to think of the possibility of earning a ton of money.  More than that -- they expect to make that money. After all (the thought process goes): "If I get in at the right time, a $100 investment may grow to $1,000 or $2,000)."

Reality check: Sure that will happen occasionally, but the most likely result is that you will lose your $100 so often that the result is an overall loss.

Basic Advice for Option Traders 

1) Do not buy cheap options (calls or puts). Inexpensive options are cheap for one of two primary reasons.

First, there is very little time remaining before the options expire. Thus, there is not much time for the underlying stock price to move far enough to generate a profit. 

Second, the option is too far out of the money and has a very small Delta. That means there is only a small chance that the stock price will increase (or decrease) by enough to turn your investment profitable. For example, when a stock is trading near $50, buying call options with a $60 strike price tends to be a very foolish investment. Not because it is impossible for the stock to rise far enough to make the call option valuable -- but because the likelihood of the stock moving 20% higher during the lifetime of the option is very small. 

The dream (big profit) dwarfs the cost of buying the calls.

However, when you consider how seldom this trade results in a profit, this investment is a money-losing proposition.

NOTE: If news is pending, and all traders know that there is an increased chance for the stock price to gap up or down) option prices are higher. No one sells those "cheap options" at a cheap price when a news announcement is expected.

[To understand why option prices are higher under these circumstances, read about implied volatility.]

2. Don't sell put options that are deep in the money. When bullish on a stock, you may adopt the strategy of selling naked put options. As long as you don't sell too many puts (sell only one put for each 100 shares of stock that you are willing to buy), your position size will be aligned with your tolerance for risk. However, some traders mistakenly believe that they can sell puts when the strike price is far in the money. For example, when bullish on a $63 stock, it is acceptable to sell puts with a strike of $55,$60, or possibly $65. But selling a put with a strike of $75 is not going to get you the position that you want. 

Why? Because the trader who buys your put will hedge his/her trade by buying 100 shares of stock at a total cost of less than $75 (if the trader cannot buy stock at a low enough price, that trader will not buy your put). Then the trader exercises the put option immediately to unload the position at a profit -- the trader pays less than $75 but collects $75 when exercising. The result is that you will own stock, and not be short a put option. That is probably not the desired position.

3. When writing covered calls, be sure that the trade allows for earning a profit. One conservative (low risk) strategy is to write ITM (in the money) covered calls. One problem arises for novice traders when the call that they sell allows zero opportunity to earn a profit. 

EXAMPLE:

Buy 100 shares of XYZ @ $54.00
Sell 1 XYZ Dec 50 call @ $4.00
Net Cost: $50.00

When expiration arrives, the best possible result occurs when the call option is still ITM and the stock is sold at the strike price, or $50 per share. This is a bad trade. Lesson: Only sell options when the premium collected is high enough to generate a profit at expiration (if the call is exercised and you are ). Careless traders may "forget" to sell options priced higher than the intrinsic value (stock price minus call strike price).
 

These are just 3 of the potential mistakes a trader can make -- each easily avoided.