10 Options Trading Pitfalls To Avoid

  1. The first question to ask in any option trade is how much of my capital could I lose in the worst case scenario not how much can I make. You can lose a high percentage of the capital you have in an option trade so keep it small in comparison to your total account size. I suggest never risking more than 1% of your trading capital on any one option trade.
  2. Long options are tools that can be used to create asymmetric trades with a built in downside and unlimited upside. The leverage is already there, if you position size correctly based on the normal amount of shares you trade you will stay out of a lot of trouble with losing a lot of money.
  3. Options should only be sold short when the probabilities are deeply in your favor that they will expire worthless, also a small hedge can pay for itself in the long run creating a credit spread instead of a naked option with unlimited risk exposure.
  4. Understand that in long options you have to overcome the time priced into the premium to be profitable even if you are right on the direction of the move.
  5. Long weekly deep-in-the-money options can be used like stock with much less out lay of capital to capture intrinsic appreciation in the underlying stock.
  6. The reason that deeper in the money options have so little time and volatility priced in is because you are insuring someone’s profits in that stock. That is where the risk is: the loss of intrinsic value, and that risk is on the buyer of the option contract.
  7. When you buy out-of-the-money options understand that you must be right about direction, time period of move, and amount of move to make money. Also understand this is already priced in.
  8. When trading a high volatility event that potential price move will be priced into the option, after the event the option price will remove that volatility value and the option value will collapse. You can only make money through those events with options if the increase in intrinsic value increases enough to replace the Vega value that comes out. This is why it is so hard to make money when holding options through earnings, the move is already priced in and that extra value is gone the next morning the options open for trading.
  9. Only trade in options with high volume so you do not lose a large amount percentage of money on the bid/ask spread when entering and exiting trades. You have to find those few option chains that have the liquidity to trade with spreads measured in cents not dollars. A $1 price difference in the bid/ask spread will cost your $100 to get in and out of a trade on top of commissions. Also be aware that the best liquidity is in the front month at-the-money options and option chains get more illiquid as they go deeper in-the-money or out-of-the-money this has to be considered in a winning trade because you might have to roll the option to a more liquid contract. Most options chains can’t be traded due to the fact that they are just not liquid enough.
  10. When used correctly options can be tools for managing risk by limiting capital at risk exposure and capturing huge trends, used incorrectly they can blow up your account.