It’s tough enough to call the direction on a stock purchase, but when you buy options, not only do you have to be right about the direction of the move, you also have to be right about the timing, writes Brian Overby of TradeKing.
In this article, I’ve analyzed ten of the most common option trading mistakes. Options are by nature a more complex investment than simply buying and selling stocks. For example, when you buy options, not only do you have to be right about the direction of the move, you also have to be right about the timing.
Option trading is not something you want to do if you just fell off the turnip truck. But when used properly, options allow investors to gain better control over the risks and rewards depending on their forecast for the stock. No matter if your forecast is bullish, bearish, or neutral there’s an option strategy that can be profitable if your outlook is correct.
Mistake 1: Starting Out by Buying Out-of-the-Money (OTM) Call Options
It seems like a good place to start: buy a call option and see if you can pick a winner. Buying calls may feel safe because it matches the pattern you’re used to following as an equity trader: buy low, sell high. Many veteran equities traders began and learned to profit in the same way.
However, buying OTM calls outright is one of the hardest ways to make money consistently in the options world. If you limit yourself to this strategy, you may find yourself losing money consistently and not learning very much in the process. Consider jump-starting your options education by learning a few other strategies, and improve your potential to earn solid returns as you build your knowledge.
What’s Wrong with Just Buying Calls?
It’s tough enough to call the direction on a stock purchase. When you buy options, however, not only do you have to be right about the direction of the move, you also have to be right about the timing. If you’re wrong about either, your trade may result in a total loss of the option premium paid.
Each day that passes when the underlying stock doesn’t move, your option is like an ice cube sitting in the sun. Just like the puddle that’s growing, your option’s time value is evaporating until expiration. This is especially true if your first purchase is a near-term, way out-of-the-money option (a popular choice with new options traders because they’re usually quite cheap).
Not surprisingly, though, these options are cheap for a reason. When you buy an OTM “cheap” option, they don’t automatically increase just because the stock moves in the right direction. The price is relative to the probability of the stock actually reaching (and going beyond) the strike price. If the move is close to expiration and it’s not enough to reach the strike, the probability of the stock continuing the move in the now shortened timeframe is low. Therefore, the price of the option will reflect that probability.
How Can You Trade More Informed?
As your first foray into options, you should consider selling an OTM call on a stock that you already own. This strategy is known as a “covered call.” By selling the call, you take on the obligation to sell your stock at the strike price stated in the option. If the strike price is higher than the stock’s current market price, all you’re saying is: if the stock goes up to the strike price, it’s okay if the call buyer takes, or “calls,” that stock away from me.
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