7 Mistakes To Avoid When Trading Options

Trading options can be appealing for many reasons, but especially for the potential to multiply your money many times over. Options can also serve as a hedge against falling stock prices and allow traders to buy and sell risk, giving them the ability to fine-tune their exposure to a stock. 

But traders can also misuse options and may make common mistakes that derail their portfolio. Trading options is generally more complicated than trading stocks, so you need to know a few key things before diving in.

Here are seven costly mistakes to avoid when trading options.

1. Not having a trading strategy

Diving into options without any sort of trading strategy is not a recipe for success. 

For example, you’ll need to answer the following questions: 

• How will you identify potential trading opportunities? 
• What criteria will you use to determine whether a trade is worth pursuing? 
• How much are you willing to lose on a trade that doesn’t go according to plan? 

If you don’t have a clearly defined options trading plan, you might end up making decisions based on emotion or what you heard in the news. When you have a trading plan, your decisions are based on whether an opportunity fits within the framework you’ve created.

Part of this trading strategy is having an exit plan. Options can make big moves in any direction, so you should know not only how large a move should trigger action on your part, but also how long you’ll wait before taking action. Will you close a position when you reach a fixed return? Or will you close out a position piecemeal after you reach specific thresholds? Or will you hold until closing? 

2. Inputting the wrong trade

With options, you have more possibilities than when you’re trading stocks — and that means more potential to accidentally enter the wrong trade information. When you’re trading options, you have both calls and puts to decide between, but you’ll also need to select the option’s strike price and its expiration. On top of that, you’ll need to decide whether you’re buying or selling the option. With a much larger number of possibilities, you can easily end up entering the wrong trade.

Worse, this setup means that you may enter exactly the opposite trade of what you wanted. For example, you may sell a call when you wanted to buy it, leaving yourself open to the substantial risks of an uncovered call — one options strategy that beginners should avoid. 

Plus, the ease of making a mistake is magnified when you’re trying to quickly input an order to take advantage of good pricing on a trade. You could easily lose hundreds of dollars in seconds by putting in the wrong options trade order.

3. Not sticking to your trading discipline

Options trading requires an acute sense of discipline and self-control. While it can provide bigger wins more quickly than investing in index funds, that doesn’t mean it will always produce immediate results. Options require you to be smart with how you trade if you want to be successful in the long run, and they require active trading and vigilance.

Because options can move quickly, you not only need a plan, but you also need to stick to it. If you don’t stick to your discipline, a big winner might become a loser, and a small loser might become a total loss. So to avoid huge losses, you’ll need to maintain your discipline and avoid the “loss aversion” bias that plagues many traders, where they continue to hold a losing position hoping that they can recoup it later. Too often the loss simply increases, particularly with options, where their value declines over time anyway. 

4. Using margin to buy options

Using a margin loan can be tempting when trading options, since it might allow you to make a nice profit without putting up much capital. The problem is that while a margin loan can amplify the wins, it does the same with losses. Buying on margin is risky, whether you use it to trade options or not. Margin calls are also a concern when trading with leverage.

It’s important that you don’t trade with money you can’t afford to lose, but trading options increase the likelihood of that happening. Because of the heavy risk associated with buying on margin, it’s like you’re doubling your risk when you use margin to buy options. So it’s similar to gambling with borrowed money, and if you lose, you’ve lost money that you didn’t have to begin with.

Options already offer plenty of leverage, so there’s no reason to amp it up even further by using borrowed money.

5. Focusing on illiquid options

Liquidity is the ease with which something can be converted into cash. Shares of stock are often quite liquid since they can easily be sold for cash whenever the market is open. But options markets aren’t always as liquid as the market for a given stock.

Options traders are at the mercy of the bid-ask spread, which is the difference between what sellers are asking for an asset and what buyers are willing to pay (bid). Spreads are often 5 cents, but may be much larger, depending on the option’s liquidity. That may not seem like a huge spread, but if you’re trading 10 contracts, the spread alone amounts to a $50 change in your profit. The spread may be larger than that. 

If there is a big difference between the bid and ask prices, you have an illiquid option. That means you might have trouble finding a buyer for your option when needed at the price you want, which can be a problem given the sometimes rapid price swings in options. 

6. Failing to understand the option Greeks

When trading options, traders must understand the dynamics of option pricing and how they work. For instance, indicators such as the delta, gamma, vega and theta of an option should be second nature to you. If you aren’t familiar with the “Greeks” of options trading, it’s best to understand them before getting started.

For example, delta represents how much the option price is likely to move based on a $1 change in the underlying security. In other words, it tells you the price sensitivity of the option relative to a change in the stock’s price. Similarly, theta explains the effect of time on the option and how much an option’s price will decay with the passage of time.

An effective options trading strategy requires that you understand these various indicators so that you know how prices will move in response to time, the price movement of the underlying stock and changes in the stock’s volatility, among other factors.

7. Not accounting for volatility

As noted earlier, the options market can be volatile. However, savvy options traders can use this to their advantage. The expected volatility of a stock influences the option’s premium, or the price an options trader pays for the contract. So understanding volatility will help you determine whether an option is cheap. A stock’s implied volatility can fluctuate over time, as traders price in events such as earnings that might cause the stock to pop or drop during the option’s lifetime. 

Your trading strategy should account for volatility so you know whether a contract is worth buying. And if it isn’t worth buying, then maybe it’s worth selling instead. Options can help you play the situation either way.

Bottom line

Options allow traders to magnify their gains, but they can be risky if you don’t have the necessary knowledge beforehand. Like most things, options trading requires learning by doing. But keeping these common mistakes in mind can help make your learning experience a less costly one.

— Bankrate contributor Bob Haegele contributed to an earlier version of this article.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.