Steve Smith details the option trading mistakes that can be the most damaging to your portfolio or trading account.
My guest today is Steve Smith of Minyanville.com, and we're talking about common option trading mistakes that traders make. Steve, give us some common mistakes that traders can make that we should avoid.
I think first and foremost is not understanding volatility, and this is most evident when people buy options and especially let's say there's an event coming out, and they don't realize what the options are pricing in, and they say, "Options don't work. Well, I bought these calls or I bought these puts and the stock moved a lot, and yet I didn't make any money", because they don't realize that the volatility came in after the event and, so, there's an old saying, actually it's probably not an old saying, I'm may be making it up, is that volatility equals opportunity, but vega, which is actually the measure of how much an option's going to change in price against every unit change in volatility. Vega equals money, so you need to understand what you're buying, and whether an option is relatively expensive or inexpensive.
I would say the other biggest mistake is simply that people try to use lottery ticket approaches, and they don't get the probability trade in their favor, so they want to use the leverage of options and buy something that seems cheap, where actually it should be low-cost, but cheap is a relative term, and they'll buy something that is out-of-the-money, and they need a tremendously large percentage move in order for that option to pay out.
And I guess on the other side of that, when you're selling or writing options people find these nice big, juicy premiums when they want to sell a put, but it's probably expensive for some reason. There's a reason why you're getting paid so well for that.
Exactly. So, selling puts you need to understand exactly that I'm going to be willing to buy this stock at a given price. Otherwise, when you're selling premium, don't think of it as free money, I'm collecting. you're not collecting anything until it's over.