TOP 10 MISTAKES IN OPTIONS TRADING
Options trading is an exciting yet risky endeavor that requires careful attention to details like liquidity, spreads, and expiration dates. Understanding and avoiding common mistakes can significantly improve your chances of success. This article dives into the top mistakes traders make and how to steer clear of them.
1. Trading Illiquid Options
Liquidity is one of the most critical factors in options trading. Liquidity refers to how easily an option can be bought or sold without causing a significant price change. If an option lacks liquidity, you may find it hard to exit your position at a favorable price. As a general rule, always trade options with open interest of at least 500 to 1,000 contracts. More liquid options, such as those tied to major ETFs like SPY or QQQ, are safer because you can enter and exit trades easily.
2. Ignoring the Spread
The spread is the difference between the bid (the highest price a buyer is willing to pay) and the ask (the lowest price a seller will accept). A wide spread can result in substantial losses. Ideally, the spread should be no more than 10% of the option's price. For example, if you're buying an option priced at $1.00, the spread should not exceed 10 cents. Tight spreads are a sign of a liquid market, while wider spreads indicate that you may have difficulty entering and exiting trades efficiently.
3. Buying Cheap or Expensive Options
Options that are too cheap may seem appealing, but they require massive price movements to yield significant profits. For example, an option priced at 13 cents may need to double or triple in value just to cover fees and commissions. On the other hand, options that are too expensive limit your flexibility because it's harder to scale in or out of positions. Expensive options, such as NVIDIA contracts priced at $2,880, also expose traders to larger potential losses.
4. Choosing the Wrong Expiration Date
Time decay (Theta) is the enemy of option buyers. Theta measures how much value an option loses each day due to the passage of time. Options with shorter expiration dates suffer from rapid time decay, which can erode your option’s value before the expected move happens. If you're unsure when a price movement will occur, choose options with longer expiration dates to minimize the impact of time decay.
5. Trading Through Earnings and Major Events
Earnings reports and major company announcements can lead to significant volatility. However, this volatility is unpredictable—stocks may drop even if earnings beat expectations. Traders should avoid holding options through earnings unless they are already profitable. The phenomenon known as "IV crush" (implied volatility crush) occurs when the price of options drops sharply after the event, regardless of the outcome. It's often better to sell your options before the earnings report is released.
6. Ignoring Federal Reserve Announcements
The Federal Reserve's decisions on interest rates and monetary policy significantly impact the market. For example, when Jerome Powell or other Fed officials speak, their comments can cause sharp volatility in stocks and options. To protect your trades, either exit positions before major Fed announcements or tighten your stops to avoid large losses due to unexpected market movements.
7. Overtrading on Third Fridays and Month-Ends
Many options expire on the third Friday of every month, and month-end trading can also be volatile due to portfolio adjustments. On these days, hedge funds and institutional investors rebalance their portfolios, causing unpredictable market swings. Reduce the size of your trades and tighten your risk management on these key dates to avoid getting caught in market noise unrelated to the stock’s fundamentals.
8. Understanding Interest Rates and Real Estate
Interest rates play a massive role in the broader economy. High rates make borrowing more expensive, slowing down growth in sectors like technology and real estate. When interest rates are high, it’s harder for companies to finance expansion, leading to reduced stock prices. Paying attention to Federal Reserve policy and how it affects interest rates can help you time your trades better, especially in interest-sensitive sectors.
9. Avoiding "Cheap" Out-of-the-Money Options
Out-of-the-money (OTM) options are inexpensive for a reason—they are less likely to become profitable. These options may seem like a bargain, but the low price reflects the low probability of success. When choosing options to buy, look for those that are at-the-money (ATM) or in-the-money (ITM), as these have a higher probability of turning profitable due to their higher Delta values.
10. Overcommitting on Third Fridays and End of the Month
The third Friday of each month is often the expiration date for a large number of options, leading to increased volatility as traders close positions or roll over contracts. Similarly, at the end of the month, institutional investors and hedge funds may rebalance portfolios, leading to unexpected price movements. To avoid getting caught in the volatility, reduce your trade size and consider tighter stops during these periods.
Conclusion
Options trading is not just about having the right strategy—execution is equally important. By focusing on liquidity, monitoring spreads, choosing the correct expiration dates, and being aware of market events, traders can avoid costly mistakes and increase their chances of success. Always remember that careful planning and disciplined risk management are key to thriving in the options market.
Disclaimer:
The information provided in this article is for educational and informational purposes only and should not be construed as financial or investment advice. Always conduct your own research and consult with a licensed financial advisor before making any investment decisions. Trading and investing involve risks, including the loss of principal, and past performance does not guarantee future results. The author and publisher of this article are not responsible for any financial losses or damages incurred as a result of following the information provided.