Derivatives are Weapons of Mass Destruction
Ten of the Biggest Mistakes in Option Trading
The following series covers ten of the biggest mistakes in option trading. Once you start reading about options you’ll soon discover that trader’s seldom agree about how to best use options and the pitfalls that await option newbies. The following are my rules and thoughts, I am sure others have different opionions.
Day One: The number one mistake in option trading is losing your shirt, losing all your money. You’d think that was blinking obvious. Yet, this mistake trips a lot of new options investors. You need to size and step in to positions. There is never such as thing as a sure thing! You have to maximise your winners and minimise your losers. Cut your losses short and let your winners run. Peter Lynch felt “pulling the flowers and watering the weeds” was the number one mistake of most investors.
Day Two: You need speed and direction. Option trading is not stock trading. You can’t buy and wait, you can’t wait for the weighing machine to deliver your profits. You absolutely need the early exit poles to show the vote is in your favour. To consistently make money buying options you need to determine the direction, speed and likely distance of your chosen vehicle.
Day Three: Not Buying Enough Time. Options allow traders to buy enough time and to be successful you must take advantage of this and buy more time. If you buy options, not paying for enough time is a critical mistake you must overcome. You are actually paying less not more. You are paying less per time unit (day, week, month). The longer the time to expiration, the cheaper options become per time unit.
Day Four: Only Buying Out of The Money (OTM) Options. Conceptually only buying OTM options is the same as mistake three, not buying enough time. Beginning options traders think that by paying less for their options they are protecting themselves from losing all their money. However, the complete opposite is true. Most things in life that are cheap are pretty worthless and the same goes for options.
Day Five: Believing Writing Covered Calls is a Conservative Strategy. Covered calls are amongst the riskiest of options strategies and should only be employed under specific circumstances. Covered calls do not protect your downside. They cap your profit leaving you holding all the downside risk and they leave you at the mercy of the market.
Day Six: LEAPS Vertical Debit Spreads are a great strategy to add to your options armoury. They deliver a swing at a home run, an 80% chance of a 100% profit and a known limited risk.
Day Seven: Trading Overvalued and Undervalued Options is not a path to riches. I’ve heard this mistake proffered as advice more times than I can remember. Believing you can profit by buying undervalued options and selling overvalued is a common mistake. At it’s heart is arrogance; a belief that you are smarter than all the other options traders out there.
Read the whole series Ten of The Biggest Mistakes in Option Trading.
Options Educational Tools
- The Options Industry Council Online Courses are excellent and well worth working through.
- Chicago Board Options Exchange (CBOE) Options Eductation also has some good freee tutorials and interactive course.
- Summary Post to RGAnthony’s excellent series on Options and their application to the BMW Method.
- Rightside Education Options Course formerly known as 21st century investor education. This site requires a free registration to access course. The options course is an excellent introduction into the world of options.
- Another options course with some good information and free tools available.
- Investopedia’s Options Dictionary provides concise definitions for most options and futures terms. So next time you wonder what the heck bilateral netting is you should click over to Investopedia.
- Options quotes from the OIC These are the best free quotes around and include implied volatility and all the greeks.
- Free Option Pricing Spreadsheet
Fusion Option Analysis
- Ten of the Biggest Mistakes in Option Trading
- Options Education. Volatility and the Greeks explained