Options trading is a popular form of derivative trading that allows traders to speculate on the price of an underlying asset. Traders do this by purchasing an options contract, which is a legal agreement between the options provider (seller) and buyer. When a trader is holding a contract, they have the right – but not the obligation – to buy or sell a specified security at a predetermined price by a predetermined date.
Trading options can be appealing, but they are a more complex product that requires a bit of evaluation and practice to get right. In this article, we will explore some mistakes that people make when they participate in options trading. We will explain what these mistakes mean, what consequences they may cause, and how traders can mitigate them.
Not having a trading plan
The first and most serious mistake people make is not having a trading plan. A trading plan is a guide – or an outline – of how you plan to execute your trades. It can consist of a variety of elements, but most trading plans include the trader’s financial objective, budget, risk profile and tolerance, trading strategy, timeframe, and risk management techniques.
If you do not have a trading plan, you may be setting yourself up for failure. This is because you will not be able to identify potential opportunities for trading. You will also not be able to decide on the instrument you want to trade. And worst of all, you will never know how you can objectively measure your success or failures. This is a surefire way to cause chaos in your trading journey.
What you should do instead
You should create a trading plan. Think carefully about why you are trading, what you hope to achieve, which markets you are most familiar with, and the kind of risk you can afford to take. This is hugely important. Setting goals and defining expectations can help you figure out where you want to go, and whether you are hitting or missing the mark. Having a system can also help you become a more efficient trader in the long run.
Not sticking to your plan
A lot of traders may have developed a trading plan at some point in their lives, and they may even have planned out their journey in detail. However, when it comes to putting things in practice, how often do you consistently walk the talk? If you are consistently making excuses or finding ways to justify deviating from the plan, you are getting almost nothing out of the plan, and you may as well trade without one.
The lack of consistency will make it difficult for you to examine the areas in which you are excelling. It will also obfuscate your progress, leading you to gloss over your trading mistakes because you do not even see them. If you make a habit of not sticking to your plan, you will also find yourself trading a lot more spontaneously and making more decisions based on emotion. This can cause you to suffer big losses if you are not careful.
What you should do instead
Once you have a trading plan, you should stick to it. If something does not work out or if someone goes well, document it. You should have an idea of which areas you are excelling in, and which areas require improvement. This way, you can zone in on problem areas and hopefully make improvements. You should adjust your plan occasionally when you have outgrown your old goals and budgets. This way, you will have a structure on your trading journey while being able to remain somewhat flexible.
Purchasing the wrong instruments
Now, when it comes to trading, there is much more emphasis on what you do with stock than the stock itself. What this means is that an experienced trader working with less desirable stocks may still be able to make a profit, because he has good technique and knows what he is doing. However, there are still certain instruments that are less desirable, and traders should avoid them when possible.
One type of ‘less desirable’ instrument is illiquid securities. This is especially true for options traders who are looking to speculate on stocks. Not all stocks are created equal. There are some stocks with fewer buyers and sellers, and they have a wide bid-ask spread because of this reason. As options trading is all about ensuring the spread is as small as possible, it is illogical for traders to purchase an option for an illiquid stock.
What you should do instead
To make sure you make the most of your trades, you should make sure you do your research on instruments in advance. This means learning about their price history, previous price patterns, and their general supply and demand. Avoid illiquid stocks, and if you are new to options trading, you may want to speculate on more popular stocks (or other instruments) that have lower bid-ask spreads.
Not researching your broker
The fourth mistake you can make is not researching your broker thoroughly before you commit to working with them. Many brokers provide options contracts for traders, and because no two brokers are the same, you may find that fees and costs will vary. You may also come up with problems like your broker not having the instrument you want to speculate on, or your broker charging you more than another one would. These are all things you should consider before you open an account, so you will not get stuck halfway through a trade.
What you should do instead
You should conduct thorough research before creating an account with a broker. This means making sure you know what fees they charge, how they price their options contracts and any additional transaction costs they implement. Make sure they have a transparent fee structure.
If you are a high net-worth individual or trade frequently, you may want to consider brokers that offer account tiers with sliding-scale cost structures. A good example is Saxo, where you can choose between individual and professional trading accounts and different platforms depending on your experience.
Not having an exit strategy
The final and most important mistake an options trader can make is not having an exit strategy. When you purchase your contract, you should know when exactly the expiration date is, how much the contract costs, and what you will do if the market moves adversely.
Even when a trade is going your way and you are on your way to making a profit, you need to figure out when you will exit the market. This involves knowing how much risk you are willing to take and how much of a profit you will be satisfied with. It is human nature to want more, and it is crucial to be reasonable with yourself.
What you should do instead
You can make better decisions by taking a longer-term view from the outset. Options contracts have expiration dates, so there is a set timeframe for every position you enter. This can be a good thing, as you can limit the time range you spend monitoring your position. As they are also decaying assets, you should never wait until the last moment to exercise them. Plan in advance and decide if you want to exercise the contract. If not, move on.
Conclusion
This is not an exhaustive list of all the mistakes that a trader can make when trading options. However, the above covers some of the more common mistakes that we see happening. If you are an offender, you should take steps to eliminate these bad practices as soon as you can, whether it means doing it by yourself or asking for help from a professional. However, you should also know that making mistakes is normal and natural, and even the most experienced traders lose money from time to time. Therefore, you should not be too hard on yourself on your self-improvement journey.
