Trading and investing for ones self is challenging at best, let alone when you are making mistakes that could have been avoided. I am of course speaking from experience as I have paid my share of tuition thanks to falling victim to a few of the following blunders.
Using an all-purpose strategy
Options can be used under a variety of market conditions. It is important for investors to have a clear understanding of what they want to accomplish. When an investor understands the dynamics of the option market as well as current market conditions, they can construct an appropriate strategy to meet their unique objectives.
Remember that each strategy has several unique considerations and characteristics that may or may not be the most effective selection based on market conditions and specific objectives.
These considerations include:
- Impact of time depreciation
- Impact of volatility
- Liquidity (the ability to get in and out of the position effectively)
The reality is that each strategy will perform differently depending on market conditions.
- Assess market conditions and determine objectives
- Research available option strategies
- Create a plan to manage the position
- Execute the trade
- Manage expectations accordingly
Taking the time to learn the unique characteristics of each strategy and subsequently selecting the “right tool for the job” can help swing the odds of a successful trade in your favor.
Buying “cheap” options
This was the first mistake I made during my formative years. Many investors look to the options market as a way to leverage their capital. As such, often the first and misguided approach is to purchase as many “cheap” options as possible. Since options with Out-Of-The-Money strike prices are less expensive relative to At-the-Money and In-the-Money contracts, this tends to be where the novice option trader migrates.
Options are priced based on the probability of whether they are going to have an intrinsic value or in other words be “In-The-Money” on expiration. The further away the strike price of the option is from the current stock price, the more likely it will expire worthless and as such, the contract is priced accordingly.
This also applies to expiration date selection. Short-term options are less expensive relative to longer dated options for the same reason. It’s more challenging to forecast what is likely to happen to the share price of a stock over a longer period versus shorter. The longer time allocated for something to happen, the greater the posibility it will happen. As such options expiring at further out expiration dates will be more expensive then shorter term options to compensate for that uncertainty.
By understanding that options are prices more or less expensive for a reason, the investor can make better, more educated decisions when it comes to strike prices and expiration date selection.
Ignoring implied volatility
Implied volatility (IV) is perhaps the most misunderstood and often overlooked pricing variable. Implied Volatility is the adjustment for risk and can be impacted by upcoming earnings and other company specific events as well as broader market/macro-economic considerations.
As risk and uncertainty increases in the underlying stock, the option price will increase to compensate for the risk.
The challenge is that this IV contraction and expansion will influence the option price even if the price of the stock does not move. For example, the chart below references the purchase of a Call option during a period of high implied volatility. Note that 3 days later, while the shares appreciated in value, the volatility contraction complete negated the influence of the stock move, resulting in a loss.
This demonstrates that you can be right about the stock move, but if you ignore IV, you may end up less profitable or even at a loss. By understanding IV and whether is high or low comparative to historical levels, you can be sure to choose an appropriate strategy.
Plan Your Actions
While the above common mistakes only represent a select few pitfalls to watch out for, having a well thought out trading plan before you act will help you identify these potential traps this ensuring that you:
- Choose appropriate contract and strategies
- Make less emotional decisions
- Feel in control
- Manage your risk and lock in profits
And ultimately put the odds better in your favour.