Top Three Biggest Mistakes Made By Options Traders
I have been trading options and coaching / mentoring new options traders for years. I have seen new traders who were blindly successful and others who were so frustrated on the verge of giving up, I have seen it all. Over the years, I have seen some very common themes among all traders, especially with options. Options trading can be very rewarding but it is not as easy as buying and selling stocks. There are many more factors and variables you must take into consideration when trading options especially if you are swing trading them or holding them for an extended period of time.
There is a certain skill it requires that is a mix of technical, statistical, and fundamental analysis. These are not skills everyone has and you have to master all three if you want to be a really successful trader. I have noticed stock traders tend to have a good amount of fundamental and technical skills but usually lack in the statistical area. This can cause a problem when it comes to their success. While trading stocks, this might be a great formula that works but when switching to options it could be a losing formula. Many traders don’t know where they went wrong.
So below are the top three most common mistakes I see new options traders are making on a regular basis that prevents them from being profitable in trading stock options:
1. Understanding Historical and Implied Volatility
Volatility plays a huge part in determining the price and value of an option. You have to remember these assets are priced based on expected fair value usually by the Black-Scholes Merton (BSM) model. Below is the formula:
But let’s face it, not many people can really understand that. All you need to know is depending on when volatility moves how the price moves with it. The easiest way to do this is to use an options trading platform like ThinkorSwim or TradeStation and let the platform do the heavy lifting to determine what-if scenarios if volatility goes up or down on price.
2. Calculating The Cost of Buying Options
Often, I have seen traders buy options way out of the money hoping for a big move. Many times, that big move does not happen, then these traders lose. Even if you buy an option at the money (ATM) you still are expected that underlying stock to move greater than the overall cost of the option. For example, let’s assume there is a stock called XYZ trading at $100. You buy a call option that expires one month out for $10. You are assuming that XYZ will move up $10 to $110 just to break even in that month. So, your real “intrinsic” cost is $110. But wait, there is more, you are expecting this to happen within one month. There is a timer on this event. So, you need a relatively big move of 10% in less than one month.
3. A Belief They Can Buy Options And Make Millions In A Short Time
It is 100% possible to buy huge positions in options and make millions in a very short time but it is not practical nor is it probable. It is really just gambling. Gambling is not a good investing or trading strategy. Sure, people have won big but for every big winner you hear about, there are thousands blowing up their account. Usually what I see is people who are successful will keep trading and just like in the casino world they will give it all back and then some. It is pretty tragic to watch this, and I actually feel more sorry for the ones that have beginner’s luck because they are the ones that end up in the worst spot. As a person who lived this myself and I have blown up my account 3 times it is not fun and it can break a person both mentally and sometimes physically. RIP to the Robinhood options trader who killed himself after not understanding how TSLA option position. Slow and steady is what wins here. Base hits and not home runs. It’s okay to go for the occasional home run but that should be a VERY small percentage of what you trade. Look for consistent income and returns from your options trades. The bottom line is trading options is not a get rich quick ideology and if anyone tells you that they are not telling the whole story.
Have a great day!
Chris Vermeulen
Chief Market Strategist