Although there is the element of risk involved in options trading, it isn’t as high risk as other methods of investments. Buying an option gives you the right to buy a financial security at a set price, as long as you purchase before the option expires. For example, you might buy an option of stocks when they are worth $10 a share. You have until 2 p.m. on November 20th to purchase those stocks at their strike price (the price they were when you bought the option) of $10. At the beginning of November, the price of the stock rises to $50 a share. You decide to exercise your option, and buy the 100 shares at $10 each. Sounds like a good deal, right? Before you enter the world of option trading, know what not to do. Here are five common mistakes many new option traders make.
- Not Having a Diverse Portfolio
Have you ever been told not to keep all your eggs in one basket? You should apply the same advice to option trading. A strong options portfolio has around five to 10 positions of varying types. You should have a combination of hedged positions with distant expiration dates, short-term positions and even some that pique your interest. A diversified portfolio lowers the chances of great losses due to one failed position. - Paying too Much for Options
In most cases, options are a more affordable way to buy company stock. However, you should keep an eye on market volatility spikes, which raises the price of options. Refer to the Chicago Options Exchange’s Volatility Index to see the impact of volatility on the market and prices. - Buying More Than you Need
Imagine you’re at the supermarket, and there’s a sale on peanut butter. The bargain is such a steal; you decide to take advantage of it by purchasing 10 jars instead of one. Did you really need all of that peanut butter in the first place? No. The same scenario translates to option trading. When you’re snatching up an option at a good price, it’s easy to forget that a single option is worth 100 shares. Ask yourself if you would realistically buy 1,000 shares before going gaga over a good price. - Waiting Too Long to Excercise Options
From the minute you purchase an option, the clock is ticking. You only have a limited amount of time to make use of your options. Whether you’re buying or selling stocks, holding out for the biggest profit can be extremely risky—especially as you get closer to the expiration date. - Being More Speculative than Sensible
Risky strategies are attractive. In an attempt to reign in some hefty profits, you may want to apply an overly speculative strategy to your trading: swing big and buy tons of options ahead of earnings. While there is a chance that you may succeed, you’re putting yourself in a very shaky position. Consider the more sensible route instead and take advantage of compounding small gains. While this certainly isn’t as thrilling as the former method, you could earn anywhere from 30% to 60% more in a year by going for safer options.
