1 Option Mistake Your Broker Is Glad You're Making

07/30/2015 8:00 am EST

Focus: OPTIONS

A common mistake that newbie options traders often make is to trade strategies that involve high commissions relative to the earnings potential, so Andrew Falde,of SMB Training Blog, shares some guidelines as to what to look for in order to avoid making this prevalent error.

A common mistake that new and developing traders make in the options market is to trade strategies that involve high commissions relative to the earning potential.

We often see newer options traders applying great options strategies to the wrong instruments.

Option trading strategies that involve frequent management to control risk can be commission intensive. This is especially true if you’re using a multiple strike trade such as a butterfly, iron condor, or iron butterfly.

Many of the popular options trading platforms that are available offer graphic analysis of options positions. Some also have an option that is not usually set by default which is to include commissions. Adding this often shows an initial starting point in the trade that may make it less attractive after you consider the amount that commissions eat into the potential earnings.

Even when you add the commissions to your analysis, this still does not show you the commissions to exit the trade. Furthermore, if any management is required, you will have additional costs which will further reduce your potential earnings.

It is not uncommon to see a multiple strike options trade on a low-priced stock or ETF have commissions that can eat into 50% or more of the expected potential profit.

The option trading strategies that we teach are typically traded on higher-priced indexes. We focus mostly on conservatively managing market neutral income trades; and these strategies involve many adjustments to reduce risk in a variety of market conditions.

Often times, in presentations that we give, we receive the question “can this strategy be traded on other stocks and ETF?” Here are some guidelines on which instruments that actively managed market neutral profiles can be traded.

In summary:

Frequently managed option strategies that involve multiple strikes are best traded on higher-priced underlying option chains. ETFs that are 1/10 the size of the related indexes also have close to ten times the transaction costs. And don’t forget to multiply the cost of the spread as well.

Andrew Falde, Contributor, SMB Training Blog

Related Articles on OPTIONS