Options

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.

Shirtless

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.
Need for Speed

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.

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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.

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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.

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