When trading options, it’s possible to profit if stocks go up, down or sideways — but the risk potential is limitless, so it’s important to understand what you’re doing if you’re considering options trading.
Read more: Options trading for beginners
Options trading vs. stock trading
Options strategies may allow you to cut losses, protect gains and control large chunks of stock with a relatively small cash outlay. But here’s the catch: You can lose more money than you invested in a relatively short period of time when trading options. This is different than when you purchase a stock outright. In that situation, the lowest a stock price can go is $0, so the most you can lose is the amount you purchased it for. With options, depending on the type of trade, it’s possible to lose your initial investment — plus infinitely more.
That’s why it’s so important to proceed with caution. Even confident traders can misjudge an opportunity and lose money.
Read on for common mistakes to avoid when options trading.
#1 Not considering your investing goals and market outlook when selecting an options strategy
When a novice investor is learning the basics, there are a few principles it’s crucial for them to understand: Namely, risk tolerance, time horizon and their goals. The same goes for options trading.
When you’re determining which options strategy to employ, think through these basic questions:
What’s my goal?
What’s my risk tolerance?
What do you think the market will do (i.e. consider volatility)?
How will time affect this strategy?
Do I have an exit strategy?
Having a strong understanding of where you stand will help you avoid a strategy that won’t serve your goals.
Learn more: Options trading with an Ally Invest Self-Directed Trading account
#2 Choosing the wrong expiration date for your options contract
When you select an expiration date, you’re estimating when you think your strategy will be most profitable. With options trading, the farther the date, the more time your strategy has to prove profitable, but it’s also more expensive (and, as we’ve established, options trading comes with limitless risk).
Consider volatility — specifically, implied volatility, which is what many investors calculate to help forecast potential movements of stock prices. There’s never an exact predictor of a stock’s price, but there are ways to make educated calculations.
To dive further, consider looking into the Greeks, which are calculations intended to show the effects of various factors on options prices.
#3 Going too high or too low on trade size
Choosing the right position size for your options trade comes down to aligning what you expect of the underlying security to your goals and risk tolerance. It’s easy to go too high to try and maximize returns and risk colossal loss … and easy to go too low to play it safe with little potential return. Whether you choose a position size by percentage of your total capital or by a specific dollar amount, the real trick is finding a balance between what you’re comfortable risking and what you’re hoping to gain — and one way you can do that is by thoroughly understanding your market outlook and the calculations you’ve done in selecting that options strategy.
#4 Trading illiquid options
Liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers.
So, illiquid options are options contracts that can’t be easily sold and thus, are often held for longer periods of time (possibly until expiration). If you’re trying to determine whether an options contract is liquid, consider looking at two factors:
Open interest: Open interest is essentially the volume of unfulfilled options contracts for a given security. Typically, the higher the open interest, the more liquid
Trade volume: Refers to the amount of activity on a given day. More activity through the day (i.e. more trades), means more liquid and vice versa
Note that these positions can change quickly, so it’s important to keep an eye on fluctuations. For instance, if there’s a sudden surge to sell a certain security, you might have trouble finding buyers and vice versa.
#5 Forgetting about volatility
Options strategies are complicated on paper — and when you put them in practice, it becomes even more complicated. It can be easy to try and block out all the noise and just put all your strategy practice into play, but that could prove to be costly. Remember: Volatility is a major and unpredictable player in the options trading game, and you can’t afford to leave it out of your equations. Consider getting familiar with ways to calculate implied volatility, so you have that in your arsenal of investing skills.
Sometimes, the right call might be to cut your losses, if that's what better aligns you to your long-term strategy — and that’s when having a plan beforehand can help you take an action that suits your goals and strategy.
#6 Not using probability when trading options
Much of options trading is about forecasting what’s next for an underlying security, and taking action based on those calculations. So, it’s crucial to use all the tools at your disposal to gain as thorough an understanding as possible about a potential option contract you’re considering.
Probability is another calculation you can use to help you forecast and make decisions. A probability calculator can help you determine the statistical chance of an options price reaching a certain amount by a set date.
#7 Not being open to new strategies … or not having a strategy at all
While it can be tempting to stick to just your tried-and-true strategies, consider learning about different options trading strategies. Remember, options are derivatives, which means their prices don’t move the same or even have the same properties as the underlying stock. Time decay, whether good or bad for the position, always needs to be factored into your plans.
As things change, you may find yourself needing to pivot away from your original strategy — if, for instance, it’s no longer going to serve your goals. When this happens, it’s good to have other strategies in your pocket to fall back on, even if it means cutting your losses with your current opportunity and moving on. It may be worth it, if it’s going to temper the risks.
#8 Having no exit plan
You’ve probably heard it before: When trading options, just like stocks, it’s critical to control your emotions. The solution is straightforward: Make a plan and stick to it.
This includes having an exit plan, even (or especially) when things are going your way. Consider setting, in advance, an upside exit point, a downside exit point and your timeframes for each exit — that way, when the unexpected happens, you have a clear plan of action that you can execute without letting your emotions get in the way.
#9 Not knowing what to do when assigned
If you sell options, it may be helpful to remind yourself periodically that the buyer may exercise the option before the expiration date, in which case, you’d be called on (aka assigned) to follow through on the contract. Lots of new options traders never think about assignment as a possibility until it happens to them. It can be jarring if you haven’t factored it in, especially if you’re running a multi-leg strategy like long or short spreads.
Early assignment can be an emotional, even irrational market event. There’s not always any rhyme or reason to when it happens. It just happens, even when the marketplace is signaling that it’s a less-than-brilliant maneuver, so it’s best to have a plan to help you keep a cool head.
#10 Failure to factor in upcoming events
Not all events in the markets are foreseeable, but there are two events you may want to keep track of when trading options: earnings and dividend dates for your underlying stock.
For instance, if there’s a dividend approaching, it may increase the probability of being assigned early if the option is already in-the-money. This is especially true if the dividend is expected to be large. That’s because options owners have no rights to a dividend. To collect, the options trader must exercise the option and buy the underlying stock.
Expanding your portfolio with options trading strategies
When executed well, trading options is an advanced strategy that can help diversify your portfolio and generate profit, but it also comes with limitless risk, more than general stock trading. By reviewing and understanding the risks associated with options trading, as well as familiarizing yourself with these common options trading mistakes, you’ll have a better chance of recognizing and stopping them before they happen.
