Two Mistakes That Ruin Rookie Option Traders

01/20/2014 8:00 am EST

Focus: OPTIONS

Price Headley

Founder and Chief Analyst, BigTrends.com

There are two major pitfalls that novice option traders make. The good news is that there are easy ways to avoid these "rookie" mistakes, says Price Headley of BigTrends.com.

When a trader or investor realizes the great leverage power of options and begins to dabble in them in their brokerage account or IRA, I've seen them make the same mistakes time and again.

I've been trading and analyzing options since the early 1990's, and at BigTrends.com, we've been educating and providing specific trade recommendations since 1999. So we've seen it all, and have learned the most common mistakes traders make, the best ways to avoid them, and how to get an "edge" over the markets.

1. Buying Very Cheap, "Lottery-Ticket" Type, Out-of-the-Money (OTM) Options
There is a reason these options are cheap! By this we mean the options that are priced at 0.25 ($25) or below, for example. These are the OTM calls and puts that can potentially give very big gains, but have a low probability of success. These options tend to have a very low Delta (which is an option "Greek" that can be interpreted as a probability of the option expiring in the money (ITM)).

Additionally, these options have no "intrinsic value" and are 100% "time premium"-so you will lose value on them due to time decay as the clock ticks towards expiration. And you may also lose value due to decay in implied volatility (option Greek Vega).

So we tend to prefer in-the-money options. These generally have a lesser amount of time premium and implied volatility built into them and have a higher Delta-so basically, you normally get more "bang for your buck" with an in-the-money option. Additionally, your overall volatility should be less when trading these versus very cheap out-of-the-money options.

2. Trading Options Without a Gameplan or Specific Targets and Rules for Taking Profits and Limiting Losses
Again, we've seen this time and again, and all traders have done this at one time or another in their trading accounts. Letting a winning trade turn into a loser, or letting a small or moderate loser become a big loser.

This comes down to discipline and having an organized set of rules. For example, if a trade doubles (goes up 100%), you may have a rule that you exit half of your position immediately, and then you basically have a "free trade" on the remainder of your contracts.

You also could have specific targets for the underlying stock/ETF/security, and when those are reached, you exit part or all of your position, regardless of where the option price is. Another valuable strategy is to have a trailing stop-loss for winning positions so that you can stay in the winners and let them run, but if it pulls back by a certain amount, you still lock in your profits. Or you can have set rules such as taking partial profits at 25%, 50%, etc.

But the bottom line is that without having systems, rules, indicators, and discipline, you are trading somewhat blindly.

And for the losing trades, we've all had them. First, I've learned through experience that the best trades tend to go your way quickly. If a "perfect" set-up is just sitting there and not going in your direction, it may be time to "cut the bait" and move on to the next opportunity.

Next, on to the problem of "hope and wait" on losing trades (also known as the trader drug of choice, "Hopeium"). This is how a small, 15% or 20% loser can turn into a 50%, 75%, or even 100% losing trade. And those can put a big damper on your portfolio and create a trading hole that you then have to dig out of.

So limit your losses to small amounts. The goal in general is to have winning trades be two to three times the size of losing trades, depending on the win/loss ratio of your strategy. Have rules and discipline in place on your option trades. For example, have a specific stop-loss, or a technical indicator that, when violated, gives an immediate exit on the position.

In general, having a clear trading plan with systems, rules, indicators, and goals will provide more confident and successful trading results over the long run.

By Price Headley of BigTrends.com

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