Options Traders – Common Mistakes

Most untrained stock options traders, and even seasoned stock traders and investors who have just moved into trading stock options, make a series of mistakes, and that really shows a lack of understanding of how options work.

Options traders have a tendency to do things in a hasty way, a tendency to underestimate numerical values and data readings as being ‘too small and not much of an issue’.

The fact of the matter is that options pricing is a tricky process that can lead to nasty surprises if the trader overlooks minor details. Because of their pricing a small change in an input variable can often result in a huge difference in the option’s profit outcome.

Here’s the list of the most common mistakes and misconceptions about the options market that lead to trading mistakes and missing the profit objective:

1. Options Traders Get The Timing Wrong

Options traders get the timing wrong, and use options with very short contract term, such as 2 months, in trades where they attempt to profit from stock price action over 2 months.

Stock options are wasting assets, it is the extrinsic value part of an option’s premium that contains the time element, and that depreciates fast and exponentially within the last 30 days of the contract’s term, in fact the remaining 50% of this time element is lost within these last 30 days!

Always buy options with at least 3 months time left. That is for trades lasting many days, if used for short term trading you can use shorter expiration times, but always make sure you have at least 30-40 days left.

2. They Buy OTM Options For Small Stock Price Action

There’s nothing wrong in buying OTM (Out of The Money) options, but these are suitable for large magnitude market moves, most traders get it wrong on the timing. Even though they could have made money trading Emini futures contracts or the stock itself, the non-linear profit curve of an OTM option is about making a lot of money on the ‘last dollar’ of a stock price move. And this takes new traders by surprise.

This means that on a stock price move from $35 to $45, you can often make next to nothing from $35 to $43 and you make a killing at $43, you make 90% of your profit on the last few dollars of the move.

In this picture we see the profit curve of a Call option on a stock priced $36.87, as you can see, you can’t make any profit at all even if the stock rallies to $38.53 (4.5% up) that would have made serious money in a large size futures contract trade, then at $38.74 (over 5% up) is just showing a $20 profit:

This option can make a fortune if the stock breaks out to $46 or higher, look at the profit projection, and all it cost to buy was $153 plus commission. But if the stock stays in a confined trading range then it is definitely not a good trade, for small price moves you are better off trading closer to the money or in the money (ITM) options. Those (ITM) options would be more expensive but they would make a profit from the very first dollar of stock price movement!

3. They Ignore The Effect Of Volatility

We know that volatility is a crucial factor in determining the extrinsic value part of an option’s premium, however many stock options traders remain focused on stock direction only and completely ignore, or underestimate volatility and its impact, you have to think both from the buyers and the sellers’ perspective, ‘How does the seller (The option writer) view the trade?’

Market volatility affects most (OTM) options, as a result, inexperienced traders may buy an (OTM) Call option on a stock that’s about to rally, but they do so when volatility and implied (expected) volatility is at its highest, and then it may collapse! As a result the option will actually decline in value even though the stock is rising somewhat. It will only become profitable if the stock rallies a lot, which is rare, most of the time stocks move up and down, or just make small gains.

As long as your objectives are clear, and you know how much your stock is expected to move, you can then decide to buy an (OTM) cheap option or an (ITM) expensive option, also you have to check with implied volatility and make sure you buy when this volatility is the lowest possible.

Stock Market Investing Strategies and Stock Market Speculation by..
Scott Smith – Invest In The Stock Market © 2008 – 2010

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