Mistake #1: Not having a strategy
Trading options offer investors the opportunity to profit in any market condition. Many investors make the mistake of understanding this reality but not properly preparing for a trade.
Investors that understand the option market and dynamics that impact prices can create a strategy that ranges in complexity from simple to advanced to achieve their financial objectives.
Some of the considerations and variables that must be understood before entering a trade include:
- Risk/reward (evaluation of upside potential versus possibility of a loss)
- Impact of time depreciation (options lose value as it approaches the expiration date)
- Impact of volatility (fluctuations in the price of the option)
- Liquidity (the ability to get in and out of the position effectively)
- Commissions (price paid to the broker to facilitate the transaction)
- Complexity (level of difficulty)
Investors who trade options should be agile
That said, each option strategy will perform differently depending on market conditions. As such, investors should be agile and continuously:
- Assess market conditions and determine objectives
- Research available option strategies
- Create a plan to manage the position
- Execute the trade
- Manage expectations accordingly
Mistake #2: Choosing the wrong strike price and expiration date
This comes back to option basics. When you pull up an option chain, you are presented with different strike prices and expiration dates. Depending on the option type (call or put), the strike price is the price that you secure yourself the right to buy or sell the underlying security and the expiration date is the date up until the option contract is valid for.
Beginners need to learn how to select the ideal strike price based on the conviction of the stock price move because there are 3 types of option moneyness: In-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM) options. The more in-the-money the option is, the more expensive it will be because it has intrinsic value* and a higher probability of being in-the-money on expiration date. On the other hand, out-of-the-money options have zero intrinsic value and require a stronger move in the stock for it to be profitable. If not, it will expire worthless on expiry.
*For call options, intrinsic value = stock price - strike
For put options, intrinsic value = strike price - stock price
As a rule of thumb, ITM options should be considered if the stock is expected to have a conservative move. ATM options could be ideal for moderate price movements and OTM options could be good for investors who have a higher risk tolerance and are expecting a large swing in the stock.
Nonetheless, picking the right strike price is one thing, but investors need to also have sufficient time for the stock to run, in the right direction, before the option expires. Hence, choosing the right expiration date is the 2nd more important factor to consider. Not having enough time is not a good place to be in for option traders. Remember that for option buyers, time is against you but for option writers (like covered call investors), time is working for you. This is why there are several expiry dates for you to choose from in an option chain. Simply make sure to trade the one that matches your market outlook and time horizon.
Mistake #3: Not taking into account implied volatility
Implied volatility is one of the most important variables to understand when pricing an option. Simply put, Implied Volatility is the expected volatility of a stock over the lifespan of the option.
Factors that would contribute towards pricing Implied Volatility include upcoming earnings, company specific events, and the broader economic environment.
What this means is that as risk and uncertainty increases in a stock, the option price may likely rise in value to compensate for this risk. That said, a jump in the stock’s price coupled with a decrease in volatility can result in a lower option price.
Consider the example below that references the purchase of a call option during a period of high implied volatility:
Purchasing a call option during a period of high implied volatility
Understanding the terms
- Stock price is the price at which a stock trades at on a public exchange.
- Strike price is the price at which a call or put option can be exercised.
- Time is the duration left before the option expires.
- Call option price is the price at which the call option trades at on an options exchange.
- Implied volatility is a prediction of how much the price of a stock will fluctuate over a given period of time.
- Delta is an estimate of the change in the option price per $1 change in the underlying stock price.
- Vega is an estimate of change in the option price per 1% change in the implied volatility.
What this means is that simply buying a call option and assuming it will gain in value if the stock moves up is an incorrect conclusion. Understanding how Implied Volatility factors into an option’s pricing will play a large role in an investor’s decision making process.
Discipline is key when investing in options
Traditional stock investors that don’t take the necessary time to study their craft are more likely to lose money through poor financial decisions. Typical errors include over-exposure to one stock or sector, not having a prudent risk management guideline in place, or not fully understanding how to follow a strategy.
As such, buying and selling options is no different than buying and selling shares.
Savvy and disciplined investors learn from their mistakes and that constantly study the market are more likely to progress towards their financial goals. This applies to investors across all asset classes, especially options.
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