3 mistakes to avoid when trading options

23 September 2022 by Montreal Exchange
Smiling man in front of a screen looking at stock charts after an option trade

Option investors of all shapes and sizes, from billionaire hedge fund managers to new investors managing $500, can make mistakes. To suggest that it is possible to avoid all errors when investing is unrealistic. But what is true is that investors can take steps to understand how to avoid careless mistakes which minimizes the potential for losses.

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 price
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 

Today 3 days later
Stock price:
$62.00 Stock price:
$66.00
Strike price: $70.00 Implied volatility:
40%
Time:
30 days Change due date Delta:
$1.21
Call option price:
$2.05 Change due date Vega:
($1.80)
Implied volatility: 70% Net change:
($0.59)
Delta : 0.304 Call option price:
$1.46
Vega : 0.06  

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.

Enroll to Canada's Top Options Trader Now to practice your Options strategy with digital assets.

Copyright © 2022 Bourse de Montréal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montréal Inc.’s prior written consent. This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This publication is not intended to provide legal, accounting, tax, investment, financial, or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Montreal Exchange, Toronto Stock Exchange, and/or TSX Venture Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication. Montréal Exchange and MX are the trademarks of Bourse de Montréal Inc. Canadian Derivatives Clearing Corporation and CDCC are the trademarks of the Canadian Derivatives Clearing Corporation and are used under license. TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license. All other trademarks used herein are the property of their respective owners.

Legal disclaimer

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus.  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

®/TMRegistered trade-marks/trade-mark of Bank of Montreal, used under licence

The articles and information on this website are protected by the copyright laws in effect in Canada or other countries, as applicable. The copyrights on the articles and information may belong to the National Bank of Canada, its subsidiaries or other persons. Any reproduction, redistribution, communication by telecommunication, including indirectly via a hyperlink, or any other use thereof that is not explicitly authorized, of all or part of these articles and information, is prohibited without the prior written consent of the copyright owner.

The content of this Web site is provided for general information purposes and should not be interpreted, considered or used as if it were financial, legal, fiscal, or other advice in any way. In addition, the information presented on this Web site, whether financial, fiscal or regulatory, may not be valid outside the province of Quebec.

This article is provided by National Bank Direct Brokerage (NBDB) for information purposes only. It creates no legal or contractual obligation for NBDB and the details of this service offering and the conditions herein are subject to change.

The hyperlinks in this article may redirect to external websites not administered by NBDB. NBDB cannot be held liable for the content of external websites.

Views expressed in this article are those of the person being interviewed. They do not necessarily reflect the opinions of NBDB.

 

 

Categories

Categories