Though potentially lucrative, this area is rife with shady promoters and pump-and-dump schemes, which pose serious investment risks.
Many new traders believe that trading volatile penny stocks is the fastest way to grow a small account.
There has to be a better way, right?
What if you could potentially get bigger and faster returns than with penny stocks by trading the largest companies and the most expensive stocks in the world for pennies on the dollar?
You can with the options market.
However, every options trader, from beginners to experienced traders, encounters potential pitfalls that can quickly turn promising positions into substantial losses.
That’s why we’ve put together the Pro Trader’s FREE eBook: How to Trade Options for Success, an essential guide that illuminates the common errors that options traders make.
This guide goes beyond listing mistakes—it provides an in-depth look at the critical missteps that seasoned traders might miss.
This guide promises to enhance your trading tactics and prevent career-ending mistakes. Whether you’re looking to broaden your trading scope or sharpen your strategies, this guide will be a valuable resource, helping you become a more skilled and successful options trader.
You’ll discover how to sidestep the most damaging blunders in options trading and turn potential pitfalls into opportunities for profit.
With that said, let’s get started!
Cardinal Sin #1: Not Understanding How Option Pricing Works
If you buy a stock, you know you’ll make money if it rises above your entry price. Because of that, many new options traders also believe that is how they work.
You buy a call, the stock goes up, and you make money, right?
Not necessarily.
You see, price is not the only determining factor that determines the value of an option.
To correctly price an option, you must know the stock’s current price, the strike price, time to expiration, stock volatility, current interest rate, and if the stock has dividends.
Sounds complicated, right?
It can be overwhelming initially, but let’s review these factors to help you get a better idea.
Below is an options calculator – you can access it yourself right here. It can help you determine many factors and scenarios affecting an option’s pricing.
Current Stock Price: As the stock price rises, the value of a call should increase, and the value of a put should decrease (all things being equal).
Notice that when the stock price rises $2, from $100 to $102, the value of the call option increases, and the value of the put option decreases. The call option value went from $1.73 to $2.93, and the put option value went from $1.71 to $0.91.
Strike Price: Options are often classified as OTM, ITM, and ATM. An option with a strike price similar to the stock price is called ATM (at-the-money).
An option with a strike price lower than the stock price is called ITM (in-the-money).
For example, the $98 call would be considered an ITM option if the stock was trading at $100.
An option with a strike price farther away from the stock price is called OTM (out-of-the-money).
For instance, purchasing the $102 calls with the stock trading at $100 would be considered an OTM call.
For calls, the higher the strike price (OTM), the cheaper the options are. For puts, the higher the stock price, the more expensive the options are (ITM).
For calls, the lower the strike price, the more expensive the options are (ITM). For puts, the lower the strike price, the cheaper the options are (OTM).
The value of the call and put for ATM options should be similar. This makes sense if the probability of stock rising or falling is 50/50.
Time to Expiration: Options are said to be wasting assets. Think of the option pricing model as a probability model. The more time, the greater the value of the option, since we don’t know how high or low the stock price can go. The less time, the lower the value of the option will be.
For example, the $100 ATM call is worth $1.73 with 30 days until expiration. However, all things being equal, that same call is worth $1.22 when there is 15 days until expiration.
In the end, the option will either close ITM or expire worthless. Options that are ITM have a combination of intrinsic value and extrinsic value.
Example:
The $98 call has a value of $2.90 and 30 days until expiration. Hypothetically, if today were expiration, the options would be worth $2 (intrinsic value).
However, since there are 30 days remaining on this contract, $0.90 of extrinsic value is added. Remember, at expiration, the only thing remaining is the intrinsic value.
Stock Volatility: The higher the volatility, the more expensive the options are. This goes for both calls and puts. The lower the volatility, the cheaper the options are. Higher volatility gives the options more extrinsic value, while lower volatility gives the options less extrinsic value.
For example, the $100 call with an options implied volatility of 15% has a premium of $1.73. That same call option at an implied volatility of 30% is valued at $3.44.
Interest Rates: As interest rates rise, the value of put options decreases, and the value of call options increases. But if you are trading options for short durations, this won’t influence the price much. After all, interest rates don’t change much over a short period.
Cash Dividends: This factor is less important than the first four discussed. However, it’s still helpful to understand how it works.
As cash dividends increase, a put option’s value increases, and a call option’s value decreases.
That said, dividends do not generally fluctuate on a short-term basis.
As you can see, several factors determine the value of an options contract.
We’ll go into some greater detail to explain where the mistakes occur.
Cardinal Sin #2: Overleverage / Oversizing
One big mistake that traders make is sizing. They think these options are cheap, and I can buy a lot of them. If they move against me, I can cut losses quickly. Or, if they are trading short-dated options, they will set a stop loss.
The problem is that option prices can move quickly. If you are trading a volatile options contract, the spread between the bid and the ask will sometimes widen.
In other words, you might not always be able to get out at the price you want.
Or if the options are volatile, you could get stopped out because you hit your max dollar loss point because you were oversized, only to see the stock turn around, and your options become profitable, but you being out of the position.
How do you fix this?
Trade smaller. For example, if you are only willing to lose $100 on a trade and the contract is a $1 premium, consider buying just one contract instead of buying five contracts at a $1 premium and thinking you will get out if the position loses 20%.
The options might move too fast for you, and you may incur a loss more considerable than expected.
If you’re constantly getting whipsawed out of your options trades, then it’s possible you are oversized on your position sizing.
Cardinal Sin #3: Not Giving Yourself Enough Time/ Too Much Time
Earlier, we mentioned that options are time-wasting assets. At expiration, an option will settle ITM or expire worthless.
Buying an OTM call option with five days to expiration might be a cheap contract. However, it’s a race to zero. If the stock doesn’t move quickly enough, those contracts will wither away worthless.
On the other hand, buying a longer-dated contract might feel like a safer bet, but you are then spending a lot more premium.
For example, let’s say NVDA is trading at $874.15, and you are interested in buying the $890 calls that expire in 3 days for a $8.35 premium. If the stock sells off those calls will get crushed. If it doesn’t move quickly enough, the value of those options will decline.
Is more time better? Well, the $890 calls expiring in 31 days go for a premium of $39. That’s nearly 4x the price for just an extra 28 days.
Ultimately, you must select the contract that fits your expectations and time frame.
The more accurate at timing the moves, the greater the likelihood of making substantial profits.
Cardinal Sin #4: Buying Options When They Are Expensive
Earlier, we stated the importance of implied volatility:
The higher the volatility, the more expensive the options are. This goes for both calls and puts. The lower the volatility, the cheaper the options are. Higher volatility gives the options more extrinsic value, while lower volatility gives the options less extrinsic value.
How can you tell if an options contract is cheap or expensive?
By making a relative comparison of the current implied volatility vs. its average.
For example, AAPL ATM calls typically trade at an implied volatility of 20%, and they are trading at an implied volatility of 30%, so those options are expensive.
Sometimes, implied volatility spikes because of an upcoming event, like an earnings announcement, that has the potential for a big move. But the premiums might be juiced at other times because the stock behaves wildly.
One tool traders use to figure out if an options contract is expensive or not is called the IV Rank.
Implied volatility rank (IV rank) is a statistic/measurement used when trading options, and reports how the current level of implied volatility in a given underlying compares to the last 52 weeks of historical data.
It runs on a scale of 1-100, with 1 indicating that the implied volatility is the 1 percentile (cheap) and 100 indicating that it is the top 100 percentile (expensive).
You don’t have to do this calculation on your own; most brokerage platforms have this feature available.
Cardinal Sin #5: Trading Illiquid Options
One of the worst feelings is buying an options contract and then getting stuck. You try to get out, but the bid/ask spread is so wide you’re staring at a massive potential loss if you’re forced to hit the bid to exit.
Ideally, you want to focus on trading options that have:
- A tight bid/ask spread
- A decent amount of daily volume, 500 or more contracts traded per day
- A healthy open interest. We like to see open interest at about 1,000 contracts or more.
If one is significantly compromised, then you are putting yourself in a disadvantage.
Open interest defines the number of outstanding options contracts, while volume represents the number of options contracts traded on a given day.
Cardinal Sin #6: Being Fooled By Randomness
One of the cool things about options is that you don’t always have to bet on direction. You can bet on where you think a stock won’t go. But a potentially dangerous strategy is being pitched as safe, and that’s selling naked calls.
While it’s true that options are time-wasting assets and that, statistically, OTM options expire worthless, there are those rare occurrences where one mistake can wipe you out.
When you sell calls naked, you collect a premium, which you get to keep all of if the contract expires worthless. However, your risk is undefined. If there is a wild move against you, you can incur heavy losses. And if you’re overleveraged, it can be career-ending.
Selling naked calls has the same risk as shorting stock, which wiped out Melvin Capital after they famously shorted GameStop during the meme-stock frenzy.
That’s why it’s always important to factor in the total risk involved and not just the probability of success when trading options.
Cardinal Sin #7: Focusing Only On Directional Bets
About 75% of the time, stocks will move sideways and be range-bound.
In addition, don’t be afraid to explore other strategies to take advantage of range-bound stocks.
While they may have funny names like condors and butterflies, these strategies can offer great risk vs. reward opportunities.
Moreover, the more advanced you get with options, the more opportunities arise. For example, making volatility bets.
Again, this shouldn’t be the first thing you want to do immediately.
Learn the basics first, avoid these seven cardinal sins, and expand your knowledge base.
Elevate Your Options Trading Quickly
Options at first may seem complex. But with the right attitude and effort, they can be your ticket to wealth in the stock market.