Options trading is a popular way for people to dive into the world of online investments because of the flexibility, leverage, and potential for significant profits that come with the experience. While options offer unique opportunities, they also carry risks, especially for beginners and those who don’t approach it with a solid plan. Many common mistakes can derail success but can be avoided with the proper knowledge.
Our guide will highlight and discuss the top 10 mistakes traders make and how to avoid them. If you can learn which pitfalls to sidestep early on in your online trading career, the further along you’ll be in developing your trading plan and fully understanding the inner workings of what you’re doing with each trade or investment.
Mistake #1: Lack of Understanding of Options Basics
Many traders dive into options without fully understanding how they work. It’s a lengthy process to become savvy with options trading—it can take weeks, months, or years to learn how it all works and the best methods or strategies to experience the best results for an online portfolio. Traders who don’t understand the concepts of options trading are doomed to experience financial losses.
An excellent place to begin is knowing key concepts like calls and puts, the two options that give the buyer the right to either sell or buy the underlying asset at a set price. Knowing how strike prices and expiration dates work within calls and puts is also some baseline knowledge that traders should become familiar with as they learn the process. The next step would be to learn about option strategies like long straddles, covered calls, married puts, and others. Understanding indicators like deltas, gammas, thetas, and vegas is helpful in knowing how options prices will move within the market.
We encourage any new or experienced traders reading this to educate themselves through resources, books, and courses before placing their first trade. The more you learn about options trading and how it works, the better your trading moves and decisions will be, which can help you avoid unnecessary financial losses.
Mistake #2: Overleveraging Trades
Options can provide significant leverage, but less experienced traders can make the mistake of overleveraging trades by handling too many traders at one time in relation to their capital. Overleveraging is essentially spreading yourself too thin in terms of time, money, and resources. It occurs when the trader borrows more money than they can realistically afford to repay. Overleveraging can lead to excessive losses even when small price movements occur within the online market.
Whether you’re a new trader or someone with intermediate or advanced experience, it’s best to use leverage cautiously. Your goal should be to ensure that each trade fits within a broader risk management strategy. Manage your capital responsibly, allocating only a small portion of your money to each trade to avoid the negative effects of overleveraging.
Mistake #3: Ignoring Risk Management
Having a risk management plan in place before trading is the best method for maximizing profits and avoiding potential losses. Some traders fall into the trap of risking too much capital on a single trade. Try using these risk management strategies and techniques to trade the most profitably.
- Stop Losses: These are orders in which traders can instruct securities to be bought or sold when its price reaches a certain point. In addition to stop losses, there are stop limits, where the trader places an order where two specific price points must be met.
- Position Sizing: To make the most of the capital you have on hand for trading, it’s best to correctly allocate money for each trade in small, conservative units. We recommend using only 1-2% of your total capital on each investment or trade opportunity.
- Set Up Limits on How Much You’re Willing to Lose: Have a limit in mind of how much money you’re willing to lose on each trade. With this plan in place, you can exit trades that no longer benefit you.
Effective risk management allows traders to retain capital by assessing their portfolio and reallocating capital to better opportunities, correctly allocating the right amount of money to each position, and knowing when it’s time to exit a position. Traders who don’t use these risk management techniques will lose money when it could have been prevented!
Mistake #4: Failure to Have a Trading Plan
Another major mistake traders make when dealing with online options is not preparing a trading plan before each new session. Successful traders always have a plan before entering a trade—they don’t make decisions by the seat of their pants. Trading on emotions or hunches can lead to erratic and unsuccessful results.
It’s best to assemble a comprehensive trading plan that includes entry and exit points, profit targets, and risk tolerance. Each plan will vary from one trader to the next, but it’s key to have a plan going into online trading to become successful in the endeavor.
- Entry and Exit Points: You have a price at which you’d like to enter the trade and a price at which you’re ready to exit. Remember that it’s best to buy low and sell high. Having these entry and exit points helps traders keep their trades and selections profitable.
- Profit Targets: Traders will have a predetermined price point when they exit a trade to lock in a profit. Profit targets are the inverse of stop-loss targets, which are the price points to which the option has to fall before the trader exits. Profit targets can be set using technical or fundamental analysis or a predetermined risk-reward ratio. These targets ultimately allow traders to maintain discipline through correct risk management and reduce their portfolio’s volatility.
- Risk Tolerance is each trader’s ability and willingness to lose some or all of an investment in the hopes of greater potential returns. It’s important for all traders to consider their risk tolerance before making any investment decision. Traders must consider their trading objectives, current financial situation, aversion to losses, and time horizon.
Mistake #5: Chasing “Cheap” Options
New traders tend to purchase cheap, out-of-the-money options without much thought, hoping for a massive profit. These options have a lower probability of success because “cheap” doesn’t always mean “valuable.” This “strategy” of chasing cheap options can often lead to consistent losses because traders aren’t even considering the idea of getting good value in the trade.
It’s better to focus on higher-quality, in-the-money options with better odds of success. Consider looking at options that are closer to the current stock price or have more time until their expiration date. While they might cost more money upfront than the “cheap” options, they have a better chance of turning a profit and bringing more value to the trader’s portfolio.
Mistake #6: Misunderstanding Time Decay (Theta)
Understanding the impact of time on any positions in your portfolio is important, especially when trading short-term options. Theta is a Greek letter that measures how quickly an option’s value decreases over time. When people use the term “theta” in trading, it indicates time decay, the reduction in an option’s price over time until it expires as worthless. Theta looks like this: Θ.
Many traders overlook how this element can affect short-term strategies—time decay is a profit killer. Many times, traders will hold onto options for far too long, allowing the price to devalue into oblivion. Others will get into options with a shorter lifespan, which are riskier to invest in because they experience a faster time decay.
Mistake #7: Ignoring Market Volatility (Vega)
A common mistake with options traders is ignoring market volatility. Knowing if implied volatility is high or low for an option is important to recognize because it can determine the price of the option premium. Implied volatility (IV) is a relative measure of what the market expects the volatility to be in the future for a given security or position. Knowing the implied volatility is also helpful in determining which options strategy will make the most sense moving forward.
Many traders overlook how shifts in volatility can significantly affect their option values. Keep an eye on volatility indicators and be cautious when volatility is expected to spike. Indicators for IV are technical tools that help traders and analysts understand and measure periods of high or low volatility in the stocks they’re focusing on or for the market as a whole.
Mistake #8: Not Using Protective Strategies
Traders often fail to protect themselves from market moves by not using hedging strategies like protective puts. A protective strategy can help limit losses and preserve capital, so traders who don’t use these hedging techniques are sure to suffer financial losses over time due to market volatility and other factors.
Protective puts are a risk-management strategy traders use to protect themselves against the loss of owning a stock or asset. Traders can execute a protective put by buying a put option for a fee (also known as a premium). They’re best used when a trader feels bullish about a stock but wants to hedge against uncertainty—they almost act like an insurance policy.
Let’s look at an example of a protective put to understand better how this hedging strategy works for short-term positions. An investor or trader with 100 shares of a stock can buy 100 put options at a strike price of $200. If the stock’s price falls below $200, the investor or trader can exercise the put by selling the stock at $200.
Mistake #9: Holding Losing Positions Too Long
Another common mistake traders make is holding onto losing positions, hoping the market will turn around. This ultimately ties up their capital in positions that aren’t working for them and allows them to incur losses that ultimately erode their capital. Traders must cut losses early and reallocate their capital to places that work for their portfolio and not against it.
To avoid holding onto losing positions for too long, traders or investors will want to set clear stop-loss levels for themselves. These are predetermined levels at which a position will be sold automatically to prevent the trader’s capital from being tied up with a losing position. The more disciplined traders can become in exiting losing trades, the more capital they will retain over time and the fewer losses they will post.
Mistake #10: Overcomplicating Trading Strategies
Using overly complex options strategies doesn’t consistently deliver stronger results than simple strategies like covered calls or selling cash-secured puts. In fact, new traders might not fully understand some of the more complex strategies, and they can work against them when put into practice before the more basic techniques. Keeping your trading approach simple can often be more effective and easier to manage.
If you’re new to online options trading, starting with basic strategies like covered calls or cash-secured puts before diving into multi-leg strategies like iron condors or butterflies is best. The more time you can dedicate to learning the simple strategy early on, the more you can understand the inner workings of your trading plan as you delve into a more complicated approach.
Set Yourself Up for Success in Options Trading Knowing the Most Common Mistakes
Knowing the most common mistakes to avoid in options trading will allow you to approach online trades and investments with more caution and insight than traders who don’t take the time to get familiar with these ordinary slip-ups that come from being new.
However, knowing the ten most common mistakes doesn’t mean you won’t experience other problems or make wrong moves in your trading sessions. When you make mistakes, it’s best to learn from them so you can plan your future trades carefully and keep risk management as a key priority.
While options trading can be profitable, it requires a disciplined approach and ongoing education. If you’re interested in learning more about options trading or working effective risk management strategies into your trading sessions, we’d encourage you to check out the following resources:
- Understanding Risk & Money Management
- Basics of Options Trading
- Options Trading Terms
- How to Prepare for Options Trading
