Option traders of every level tend to make the same mistakes over and over again. And the sad part is, most of these mistakes could have been easily avoided. In addition to all the other pitfalls mentioned in this site, here are five more common mistakes you need to avoid.
So why make it harder than it needs to be? Always have a plan to work, and always work your plan. You should have an exit plan, period — even when a trade is going your way. You need to choose your upside exit point and downside exit point in advance. You also need to plan the time frame for each exit. Options are a decaying asset. And that rate of decay accelerates as your expiration date approaches.
The flipside is that you are exposed to potentially substantial risk if the trade goes awry. The bottom line is: What if you profit more consistently, reduce your incidence of losses, and sleep better at night? Trading with a plan helps you establish more successful patterns of trading and keeps your worries more in check. So make your plan in advance, and then stick to it like super glue.
Traders always have their ironclad rules: So it can be tempting to buy more shares and lower the net cost basis on the trade. What can sometimes make sense for stocks oftentimes does not fly in the options world. Although doubling up can lower your per-contract cost basis for the entire position, it usually just compounds your risk.
Close the trade, cut your losses, and find a different opportunity that makes sense now. Options offer great possibilities for leverage using relatively low capital, but they can blow up quickly if you keep digging yourself deeper. Oftentimes, the bid price and the ask price do not reflect what the option is really worth.
This activity drives the bid and ask prices of stocks and options closer together. The market for stocks is generally more liquid than their related options markets. At-the-money and near-the-money options with near-term expiration are usually the most liquid.
So the spread between the bid and ask prices should be narrower than other options traded on the same stock.
Consequently, the spread between the bid and ask prices will usually be wider. After all, if the stock is inactive, the options will probably be even more inactive, and the bid-ask spread will be even wider. That cent difference might not seem like a lot of money to you. In fact, you might not even bend over to pick up a quarter if you saw one in the street. First of all, it makes sense to trade options on stocks with high liquidity in the market.
A stock that trades fewer than 1,, shares a day is usually considered illiquid. So options traded on that stock will most likely be illiquid too. Obviously, the greater the volume on an option contract, the closer the bid-ask spread is likely to be. Because while the numbers may seem insignificant at first, in the long run they can really add up.
There are plenty of liquid stocks out there with opportunities to trade options on them. We can boil this mistake down to one piece of advice: Always be ready and willing to buy back short strategies early.
When a trade is going your way, it can be easy to rest on your laurels and assume it will continue to do so. But remember, this will not always be the case. If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Here's a good rule-of-thumb: Very rarely will it be worth an extra week of risk just to hang onto a measly 20 cents.
This is also the case with higher-dollar trades, but the rule can be harder to stick to. Option trades can go south in a hurry. Every trader has legged into spreads before — but don't learn your lesson the hard way. Always enter a spread as a single trade. Just keep in mind that multi-leg strategies are subject to additional risks and multiple commissions and may be subject to particular tax consequences.
Please consult with your tax advisor prior to engaging in these strategies. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options.
Options investors may lose the entire amount of their investment in a relatively short period of time. Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract.
There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy.
The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.
The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. What if you get out too early and leave some upside on the table? Not too appealing, is it? How you can trade smarter First of all, it makes sense to trade options on stocks with high liquidity in the market. Waiting too long to buy back short strategies We can boil this mistake down to one piece of advice: How you can trade smarter If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it.
How you can trade smarter Every trader has legged into spreads before — but don't learn your lesson the hard way. Back to the top.More...