Options trading is a type of investment that allows investors to speculate on the future price movement of an underlying asset. The critical feature of options contracts is that they grant the holder the entitlement, but not the duty, to buy or sell the underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date). There are two types of options: call options and put options.
Options trading can be a profitable endeavor, but it also carries a high degree of risk. To succeed, options traders must have a thorough understanding of the contracts they are entering into and the risks involved. Unfortunately, many traders make avoidable mistakes that can cost them dearly.
Not Understanding Options Contracts
One of the most common mistakes options traders make is not understanding the contract they are entering. An option contract is a legal agreement between two parties – the buyer and the seller – and as such, it is subject to specific rules and regulations. Traders must familiarise themselves with these rules and regulations before entering any options contract.
Failing to Manage Risk
Another common mistake made by options traders is failing to manage risk appropriately. Options trading is risky, and there is the potential for substantial losses. As such, traders must understand how to manage their risk. Several ways to do this include using stop-loss orders, position sizing and diversifying your portfolio. You can diversify your portfolio by investing is various assets, like stock options.
Not Having a Trading Plan
One of the essential things for any trader – regardless of what they are trading – is to have a well-defined trading plan. A trading plan should outline the trader’s goals, risk tolerance, and investment strategy. Without a trading plan, it is straightforward to make impulsive, emotionally-driven decisions that can lead to substantial losses.
Many traders, especially newbies, make the common mistake of overcomplicating things. There are various strategies and indicators that traders can use in options trading. However, this does not mean that they must use all of them. Too many indicators and strategies can lead to confusion and poorer performance. Sometimes, simplicity is best.
Chasing After Losses
It is human nature to want to recoup losses as quickly as possible. However, this is not a good strategy for options trading. When a trade goes against them, many traders will double down and make additional trades to make up for the loss. It is often referred to as “chasing after losses”, and it is one of the quickest ways to lose all your capital.
Holding Onto Losers for Too Long
Another common mistake of options traders is holding on to losing positions for too long in the hope that they will eventually turn around. It is often referred to as “hope trading”, and it is generally a bad idea. It is important to remember that options contracts have an expiration date, so there is always a time limit on how long a trader should hold a position.
Not Cutting Your Losses
Many traders are reluctant to cut their losses for fear of realizing a loss on their investment. However, this is often the best course of action when a trade is not going as planned. You are simply increasing your risk and exposure by holding on to a losing position.
Failing to Use Limit Orders
When buying or selling options contracts, it is essential to use limited orders. A limit order is when a trader buys or sells a security at a specified price or higher. It ensures you do not overpay for the options contract you are buying or sell for too low when closing out a position.
It is only natural to want to make a profit on every trade. However, this is not always possible. Sometimes, the best action is to take a slight loss and live to fight another day. Many traders get caught up in the idea of “winning big”, and as a result, they often end up losing even more.
Not Sticking to Your Strategy
Traders need to have a well-defined strategy before entering into any trade. Once a trade is made, it is vital to stick to the strategy and not deviate from it. Many traders make the mistake of abandoning their strategy mid-trade, and this often leads to poor results.