5 Options Pitfalls to Avoid

11/21/2011 8:00 am EST

Focus: OPTIONS

Veteran options trader Steve Smith identifies the most common mistakes that options traders need to know about and steer clear of at all costs.

1. Swinging for the Fences Ahead of Earnings
When people talk about trading options, the conversation usually turns to ultra-risky strategies. By far, the most common of these is buying call or put options ahead of an earnings number in the hopes of hitting a home run. The upside in being right about such an unpredictable event is a big fat profit.

The downside when you're wrong? That'd be 100%. As in, the underlying stock gaps against you, the options are left worthless.

There is nothing wrong with making the occasional speculative bet, but you have to understand the risk involved and keep the position right-sized.

2. Failing to Understand Implied Volatility
Being wrong on a stock's direction is clearly an easy way to lose money. But there's a second, and perhaps even more frustrating way to lose money with options: failing to understand the intricacies of option pricing.

One of the biggest mistakes new options traders make is not taking into account implied volatility, which is a measure of the expectation or probability of a given size move within a given time frame. Put simply, implied volatility provides a gauge as to whether an option is relatively cheap or expensive based on past price action in the underlying stock, and it is among the most important components in option pricing.

I can't tell you how many times I've heard traders say "options don't work" because they bought puts or calls ahead of earnings, were right on the direction of the stock post-earnings, but the option barely changed in price implied volatility declined post-earnings as is common after expected news events.

Therefore, in order to consistently make money trading options, one must attain a basic understanding of implied volatility.

3. Failing to Understand Time Decay
Traders also commonly fail to realize that options are a wasting asset. One very important component in the price of an option is the time until expiration. So as time goes on, the value of that time decays, with a negative impact on the overall value of the option itself.

If you buy calls or puts outright, and the underlying stock moves in your direction at a slow pace, the option may not gain in value.

However, a basic understanding of option pricing and a grasp of a variety of trading strategies will allow you to offset the impact of time decay-or even turn it to your advantage.

4. Ignoring the Power of Compounding Small Gains
Above, we referenced the risk in swinging for the fences with options. The less-sexy-but far more lucrative-reality is that the best options traders grind out steady profits using a wide variety of strategies, looking to consistently earn 2% to 4% a month, with an occasional kicker from speculative bets.

Two percent per month doesn't sound like a lot, but compounded over a year, it adds up to 27%. That's more than three times the average historical return for the S&P 500 (SPX). Stretch that monthly gain from 2% to 4%, and the annualized profit is on the order of 60%

The important takeaway here is not the idea of making 60% in a year, but rather the power of consistently hitting high-probability singles rather than swinging for low-probability home runs every time we step up to the plate.

Extreme risk-taking could mean that you're up 100% one month-and down 50% the next. You do that and you're right back where you started, but with an ulcer and heart medication.

There is plenty of room for speculation with options, but to stay ahead of the game, you have to pick your spots wisely.

5. Failing to Diversify
Ideally, no single position should represent more than 5% of a portfolio. These can run from complex, multi-strike hedged positions that have four to six months until expiration, to speculative plays based on unusual activity or an upcoming event that will be held for just a few days.

Why? Because again, I never want to get knocked out of the game on one trade, or allow a position to get so large that it could threaten gains elsewhere in the portfolio if things go south.

When people go broke trading options, it's usually because they not only swung for the fences on an earnings play, but put far too much money into that single trade.

By Steve Smith

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