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7 Critical Mistakes to Avoid While Trading Options

Mistake number 3 just might be the worst one

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Introduction


Options trading is a great way to make money in the market, but it can also be risky. In fact, many professional investors avoid trading options because of the potential for heavy losses with limited upside potential—a risk/reward ratio that's not favorable to most people who trade.


However, if you learn how to manage your risk while maximizing your profits, then this low-risk strategy can be a great addition to your portfolio.


That said, there are still some mistakes that even experienced option traders make along the way. Here are some of those mistakes and how you can avoid them:


Mistake #1 Trading options without a defined strategy.


It's important to define the problem before starting on a solution. If you don't have a clear idea of what your goal is, it will be difficult to figure out how to get there.


For example, if you set out without knowing how much weight you want to lose, how many miles you want to run or how fast your mile time needs to improve by (or any other fitness goal), then it's hard for us as coaches or trainers or even friends and family members who care about your well-being and happiness not only as an athlete but also just as a person in general—to help.


You don't need our advice though! You've already figured out what your goals are from reading this article so far. Now we can move onto some tips on how best go about achieving them!


Mistake #2 Neglecting to study the options chain.


The options chain is the key to navigating the options market. If you don't know how to read it, you're going to have a hard time making wise trades.


If you're serious about getting into options trading and making money, take some time to learn about reading an options chain.


The first step in learning how to use an options chain is understanding what it actually is. The main component of an options chain is its expiration date, which shows when a particular option expires.


Underneath that information are details on strike price (the price at which you can purchase or sell your chosen option), bid/ask prices (how much someone is willing to pay for or sell an option), volume (how many people want or are selling each contract), open interest (how much has been traded recently), volatility percentage (.25% = 25% volatility) and last trade price ($2).


This data will help inform your decision making process before entering into any kind of transaction involving these products so keep it handy at all times!


Mistake #3 Trading low probability options setups.


It is important to understand the probability of success for an options setup, and it is also important to make sure that the probability of success is high enough.


For example, let's say you're looking at a daily chart where the price action has been very choppy and volatile, but there are several signs that things are starting to settle down. For example:


Price has been moving in a narrow range (relative to its recent history) over several days or weeks.


Volume has been low relative to other times during this period of low volatility.


In this type of situation, your best bet might be just waiting for price action to stabilize before entering any trades based on this setup because there isn't much conviction behind the current price action and thus there may not be much conviction behind any options trades either; hence why I have said "low probability."


Mistake #4 Trading options with a small account size.


Trading options with a small account size is one of the biggest mistakes that you can make when trading options. The reason for this is because if you have a small account, then the number of contracts that you can trade is very limited.


When trading with limited capital, it becomes difficult to make money in the market.


The best way to avoid this mistake is by only trading with a small percent of your account and/or capital at any given time. For example, if someone has $50,000 in their brokerage account then they should only be risking around 2% per trade (which would mean risking about $1k).


Failing to understand the risk of early exercise for American Style options.


Early exercise is a risk that the option seller faces. The buyer has the right to exercise the option before expiration date and if he does, then he will receive the underlying asset (stock), at the strike price agreed upon during contract initiation.


In other words, if you are selling an American style option and your client exercises it early then you’re going to have to buy back that stock from him at a higher rate than what he originally paid for it.


Mistake #5 Buying too many options contracts.


Buying too many options contracts is the most common mistake and one that can be easily avoided. The problem is that, unlike stocks, you don't have to buy whole lots of options.


You can buy as little as one contract at a time and this opens up the possibility of buying more than you need.


If you're trading with an automated system or if your broker has an auto-trade feature (which I do not recommend), then this may be something that happens without your knowledge. You'll be surprised how easy it is for your "set it and forget it" strategy to suddenly turn against you when those trades start piling up on the wrong side of their positions!


The good news here is that there are several ways around this problem: use limit orders; use stop loss orders; use trailing stop orders all help keep losses contained and allow for better management of risk going forward.


Mistake #6 Selling naked calls (or puts).


This is a high-risk strategy and should be used only by traders who have experience in options trading. You are selling a contract without owning the underlying asset, which means that you are betting that the price of the stock or index will not reach or exceed your set strike price by expiration.


If it does, you will be required to buy shares at their assigned strike price—which could be much higher than market value if you're short on time before expiration—and sell them on the open market at likely lower prices.


Mistake #7 Not selling options in time to avoid losses.


If you buy options and then decide not to exercise them, the time value of your option will erode away until it becomes worthless. This is called “time decay” and it happens whether or not you’re in the money (ITM) or out of the money (OTM).


In other words, even if your option expires OTM and you don’t exercise it, you will still lose that initial investment as a result of time decay. The same goes for when your option expires ITM: If you don't sell or exercise it before expiration day, then your initial investment will be gone forever because there was no way for anyone else to benefit from its value.


You must therefore always keep track of how far from the money an option is; if an OTM call costs $0.15 per share today but has four days left until expiration day at which point its price would fall below $0.10 per share—and there's no way that one could make more than $0.05 profit on this trade—then selling now would be wise so as not to risk losing any more money than necessary by allowing these last few days' worth of time value being eaten away unnecessarily by "time decay."


Avoid these common mistakes when trading options


Trading options without a defined strategy. Before entering into any option trade, it's important to have an objective. Do you want to speculate on the direction of a stock?


Is your target profit percentage a certain amount? What are your stop-loss points? The answers to these questions will help guide your trading decisions, so be sure to consider them before each trade you make—and adjust accordingly as market conditions change.


Neglecting to study the options chain. Understanding what makes an option valuable and how its price changes over time is crucial for successful option trading—and being able to read an options chain is one of the easiest ways of doing so!


As basic as it sounds, knowing where each strike price sits relative to others is essential knowledge when determining whether or not (or at what price) you might enter a trade on any given contract.


It also helps keep things simple: if there's no potential value left within that contract based on current underlying stock prices and implied volatility levels (IV), then moving down one tick level isn't going yield better results than staying out altogether - though that does depend upon how much risk tolerance individuals have set aside for themselves and whether or not they're willing


to risk losing more money than what was originally invested overall when opening up position size limits aren't reached priorly set before committing funds against potential losses incurred should there be insufficient capital available after all costs associated with buying into positions are accounted for including commissions fees etcetera."


Conclusion


We hope that this post has helped you to avoid some of the common mistakes that are made when trading options. Trading options can be a great way to make money if done correctly, but it’s important to understand the risks involved before diving in headfirst. If you heed our advice and avoid these common pitfalls, then we have no doubt that your option trading will be more successful than ever before!


Get started today with Options trading and join our Premium community where you will get access to 3 alerts daily as well as access to multiple other platforms we provide for our premium community.







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