The trading of equity options has become an incredibly popular vehicle for investors. However, like any investment, options carry inherent risks. An educated investor will often follow a specific method or course of action while trading options, to minimize risks and to generate consistent income.
Let’s take a few moments to outline the top mistakes to avoid when trading options.
To start with, an investor should be fully educated on all the aspects of options: what they are, how they are traded, and how they function. First, a trader should know the difference between a call and a put.
Call: A call option is a contract giving the buyer the right, but not the obligation, to purchase shares at a predetermined price
Put: A put option is a contract giving the buyer the right, but not the obligation, to sell shares at a preset price
Next, you must know the difference between buying an option vs. selling. When you buy an option, you pay a premium, but get the right to decide if the contract will be exercised. If you sell an option you are paid a premium but have the obligation to fulfill the contract if the option buyer exercises his or her right. When combining calls, puts, buying, and selling, you can quickly see that option trading is more complex than simply trading stocks.
Option investors should also be familiar with some unique terminology that applies only to option trading and option contracts.
The strike price is the price at which shares are bought or sold.
The expiration date is the date on which the option contract expires.
When entering an order, you should pay careful attention that all information related to the contract is entered correctly. You can find all the different strike prices and expirations on the option chain. Not fully understanding these aspects of options or misentering one while trading is one of the most common mistakes of new option traders.
Understanding the basics of options is important, but having a plan of action to utilize them in your trading is also key to consistent returns. Investors who do not have a plan for their options trading can be susceptible to the temptation to engage in practices such as speculation or market timing.
Speculation refers to the trading of securities in the belief that the security will have a significant change in price in the short term. Speculators often expect to achieve extremely high returns without a good grasp of the potential risks. While you can get a speculative bet correct from time to time, it is impossible to guess these trades correctly consistently.
Market timing is synonymous with speculation. Countless studies and decades of investment results have proven that no one can time market tops and bottoms consistently. That means you need to create a plan that will work in all the different market conditions.
Frequently, investors will also use options because of their leverage capabilities. Again, this is an attempt to achieve excessive returns with less capital at risk. Since option contracts represent 100 shares, you can quickly control a lot of shares at a fraction of the cost. New option investors can also underestimate the total capital required when trading multiple option contracts. Finally, if the investment in question does not produce the results the investor hopes for, the potential loss that they will suffer can be compounded.
Of course, the importance of having a plan does not mean that every type of plan that a trader can pursue is appropriate. Many options strategies carry significant degrees of risk and are simply inappropriate for most investors. Buying calls and puts have an inherent risk; when you purchase these options, you are essentially betting on whether or not the price of the underlying position will go up (or down). If the desired result fails to occur, you risk losing the premium that you paid for the options that you bought. Buying a single option without holding the underlying stock or using a combination of options is often an all-or-nothing bet.
Selling certain options can also bring risk, however, and in a far greater proportion. Many investors engage in the selling of covered call options, the selling of a call for which you own a bundle of shares that can be sold if the buyer chooses to exercise the option. Covered calls are one of the most common, least risky options strategies. It is a great place for new option traders to start to gain experience.
Some investors, however, engage in the selling of naked calls. This refers to selling a call option when you do not actually own a bundle of shares to cover the option if it gets exercised. Selling a naked call is very risky; the seller is making a bet that the price of the option will not go up (essentially, the opposite of what the purchase of a call option is hoping for). If the price does go up, and the buyer chooses to exercise the option, the seller must purchase a bundle of shares at the current market price and then immediately sell them at the strike price of the option. The strike price will be less than the market price the seller had to pay to purchase the shares; because the price of the shares has no ceiling, the risk for the seller of the naked call is unlimited.
Buying or selling a single call or put is known as a one-leg trading strategy. However, there are also more complex multi-leg strategies that investors can trade. Examples of multi-leg option strategies include straddles (where an investor will buy both a call and put option at the same strike price) or a strangle (where a call and put are bought at different strike prices). Because these strategies involve the purchase of multiple options, the premium paid is increased, as is the risk. Investors should also take time to determine how income or profit will be made off of a multi-leg option trade; most strategies of this type are dependent on a specific sequence of events occurring in order for the trade to be profitable to the investor.
While the above explanation may make it sound like there is a limitless number of pitfalls that can befall an options investor, the reality is far different. Options trading has proven popular with investors due to its reliability and the consistent returns that can be generated. The key to successfully trading options is to adopt an appropriate strategy, learn all the facets of trading it, and trade it consistently over the long term.Posted in Options and Options Trading |