New option traders can make many mistakes when they first start trading options. Here is a quick list of what to do and what not to do as you come into the options market for the first time says Steve Burns of New Trader U.
Are Options Good for Beginners?
“Fish see the bait, but not the hook; men see the profit, but not the peril.” –Chinese proverb
Options can be both a great wealth-building tool and a quick way to lose all your trading capital if you overleverage your trades. Disregarding the odds of your option trade being a winner can lead to outsized bets that lead to zero dollars in your account.
Option contracts can go to zero by the expiration date or up 100% right after entry. Option traders must always manage both possibilities based on an option's probability of movement by expiration. The Delta of an option is a good probability indicator, it is part of the option pricing model.
An at-the-money option will have approximately a .50 Delta as it can move to equal in-the-money in either direction. A deep-in-the-money option will have nearly a 1.00 Delta as its price moves with the stock price dollar for dollar. An option far out of the money can have a Ten Delta if it has approximately a 10% chance to go in the money by expiration. Delta for an option contract can approximate the odds for new option traders and help them choose their position size carefully.
Options can be used to overleverage and blow up your account with big all-or-nothing bets. Or they can be tools for asymmetric risk management by only deploying small amounts of capital but capturing full moves in your favor.
Options are also tools professionals use to hedge their stock positions to limit their downside losses. Here are what I believe are the seven biggest mistakes new option traders may make if they are not familiar with how options work.
What Should You Not Do When Trading Options?
Too many times new option traders become obsessed with buying far out-of-the-money options without fully understanding how far the odds are stacked against them. They become gamblers looking to play the lottery. If the Delta is only .10 or on your option then you have less than a one in ten chance of your option expiring in the money.
Even if you get a move in your favor your far out-of-the-money option will not increase in value until the Delta expands enough to overcome the time decay. It takes a huge move in price to increase the value of out-of-the-money options. The odds of it expiring in the money have to increase enough to drive up the contract price.
New option traders can become frustrated when the price moves in their favor and their out-of-the-option goes down in value! The delta must expand faster than the time value decays. Options with at least a .25 Delta will double your odds of success a lot from a one in ten chance of profit on expiration to a one in four chance of being able to go in the money and grow quickly in price as the delta expands more easily with a move in your favor.
Also, an option trader doesn’t have to wait until expiration, an option can be sold to lock in profits at any time in its life span. Most of the time it is better to lock in option profits while they are there and not get greedy for more gains. Option contracts are deteriorating assets and time is not on the side of the option buyer.
Many new to options don’t understand that you cannot trade options in all stocks, you need open option volume to create liquidity, so the options have a tight bid/ask spread. It’s not wise to trade illiquid options because you can lose 10% or more of your capital in a position just in the entry and exit of your trade. If the volume is not there to tighten this spread executing option trades can be expensive.
Look to see how much it will cost you to get in and out of an options trade before trading any option chain. You want to see option spreads of a dime to fifty cents at most preferably. A dime bid/ask spread on an option will cost you $10 to get into the trade and then $10 to get out. A 100-share contract times ten cents a share equals $10 each way. This is a $20 round trip in addition to your commission fee and this is only for one contract.
A $1 bid/ask spread will cost you $100 in slippage to get in and then $100 or more to get out of one contract. This is a trading expense that compounds over time, the moment you enter a one-contract option with a $1 bid/ask to spread you are already down $100 with the slippage. Only trade in the most liquid option contracts on the leading stocks and stay away from the low-volume markets that will slowly eat away at your trading capital through slippage.
Always buy an option that is in line with your trading time frame. Give your trade enough time to work. If your plan is that Apple goes to $200 in one month, don’t buy a weekly $200 strike call, you’ll run out of time, and it will expire worthless. Buy at least a month-out call option that will not expire before your trade has the time to play out. In options you have to be right about the price and time frame, just one or the other is not good enough for profitability. You can be right about the price but run out of time on your option or you can be right about the move but buy an option too far-out-of-the-money or too expensive to profit from the move.
It’s crucial for option traders to understand the implied volatility that is priced into options above the normal time value before earnings announcements or some other uncertain news event and that the Vega premium is priced out of an option after an uncertain event is over.
If an at-the-money weekly Apple call option and put option is trading at $10 above normal time value on the day before earnings are announced the day after earnings that $10 in Vega value will be priced out of the option contract. The option trade is only profitable if the intrinsic value of the option going in the money of the strike price chosen is more than $10 to replace the lost Vega value.
When trading through a volatile event like earnings you must be right about the magnitude of the price move to be profitable, the direction alone is not enough. You will see that buying options through earnings has a low probability success rate because the option sellers give themselves plenty of Vega value to cover their risk of selling options through earnings. It’s very difficult to overcome this Vega collapse. Many will tout the few times the move was not priced in but that is a low probability event. Short straddles can be more profitable through earnings than one-sided long option bets on direction due to volatility crush.
With in-the-money options, you take on the risk of intrinsic value, but you only have to be right about the direction. In-the-money options have little Theta or Vega value they are almost all intrinsic value and have very high deltas over .90 and with the right liquidity and going with deep-in-the-money options can be used like one-sided synthetic long stock positions but without the same level of downside risk. Deep-in-the-money option positions also require less capital to hold the same leverage a stock position allows.
Don’t risk more with options than you would while trading stocks. Never risk more than 1% of total trading capital on any one option trade. If you can only trade 100 shares of Apple in your trading account, then only trade one Apple in-the-money option contract. If you’re trading capital is large enough to handle trading 1000 shares of stock in your normal stock trading account, then trade ten contracts of those options.
Don’t trade too big with options, while they can double and triple in price, they can also go to zero. Options can move so fast that it is difficult to have stop losses on the option price itself. It’s much easier as an option trader to simply have option trades be all-or-nothing trades with small positions in most cases. A 50% stop loss on an option is the best you will likely be able to manage a lot of the time with most option plays. Stop losses have to be on the chart of a stock where they have meaning at a technical level and not at a random option price decline level. This is why I prefer all-or-nothing option trades and using the stock price.
Unlike stocks that are tied to ownership in a company, options are derivatives of stocks and simply contracts that will expire. They are not assets, they are bets. Options are a zero-sum game, there is a winner for every loser in the option market. For every option contract bought someone wrote that contract. While trading with options to be on the winning side you always want to trade with the odds in your favor. If you are a seller of premium sell the out-of-the-money options that have little chance of being worth anything.
Option buyers can buy to open the in-the-money options in the direction of the current market trend. Option premium sellers can sell to open put options under the support of the hottest stocks during bull markets and sell calls on the stocks in downtrends. Avoid the temptations of big premiums for selling puts on volatile stocks and calls on growth stocks in strong trends, which can be dangerous.
With options don’t buy low probability far out-of-the-money lottery tickets, sell them. Don’t cap your upside on a hot stock by selling a covered call instead buy a call option and get the upside for a small position size of capital. Be on the right side of the probabilities and manage your risk and you will do very well over the long term if you have an option strategy with an edge.
Approach your option trading like a casino operator, not a gambler. Set bet size limits for yourself. Understand and respect the odds of success on any trade and manage your maximum risk exposure of every option trade carefully.
Don’t try to get rich quickly, your first priority is to conserve the capital in your option trading account with small bets. When you start trading options strive to make small mistakes in your trading, not large mistakes. There is always someone on the other side of your option trade so trade carefully, it’s not easy money it’s a game that you have to play better than other traders.
Learn more about Steve Burns at NewTraderU.com.