Options trading is a type of investment strategy where investors buy and sell contracts that give them the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and within a specified time frame.
In options trading, investors are essentially betting on the future movement of an asset’s price and can use options to either hedge risk or speculate on potential gains. Options trading can be complex and risky and requires a solid understanding of both the underlying assets being traded and the mechanics of options contracts.
In this article, we aim to examine some of the most common options trading mistakes traders of all levels may be making. We will also discuss how you can get rid of these bad habits and build better ones. If you want to trade options, you can visit Saxo. Or you can read on to discover the 7 mistakes to avoid when trading.
Not having a plan
Before entering into any options trade, you need to have a clear plan in place. This should include your entry and exit points, as well as your risk management strategy. Without a plan, you’re essentially gambling with your money, which is never a good idea.
How to create a trading plan
To begin with, a trading plan should be a comprehensive document that serves as a roadmap for your trading activities and provides guidance for making informed trading decisions.
A trading plan should therefore consist of your goals and objectives, trading strategies, risk management techniques, rules for entering and exiting trades, market analysis methods, and a review process to evaluate and adjust the plan over time. It should also take into consideration your personal circumstances, such as their risk tolerance and financial situation.
Not doing your research
Just like with any type of investment, you need to do your due diligence before trading options. This means researching the underlying stock, analyzing market trends, and understanding the risks involved in the trade. Failing to do so can lead to costly mistakes.
How to do market research
When conducting market research, you should first identify the underlying asset you want to trade, such as a stock, index, or commodity. You can then conduct research on its historical performance, price trends, and volatility. You should also consider market conditions. To do this, you can use technical analysis tools to evaluate market trends and price movements.
In options trading, you should also do research on options prices and their premiums. This can include using options pricing models to estimate the fair value of an option, and then using the results to compare it to the current market price.
Not using stop-loss orders
Stop-loss orders are an essential tool for options traders. They allow you to automatically exit a trade if it moves against you, limiting your losses. Failing to use stop-loss orders can lead to catastrophic losses.
How to use stop-loss orders and other risk management tools
Stop-loss orders are great to limit potential losses, and they are part of a wider set of risk management tools you should be using when trading options. To do this, you can first determine your risk tolerance, which means knowing the amount of money you are willing to risk on a trade and setting a maximum loss limit.
Then, you can set a stop-loss order, which means choosing a price that allows for some market volatility but also limiting potential losses to an acceptable level. This is the price at which you will automatically sell your option if the market hits it. You can also set other orders such as the trailing-stop, which allows you to lock in profits as the price moves according to your plan, while still limiting potential losses. Other risk management techniques you can investigate include hedging and implementing position sizing.
Not understanding the Greeks
The Greeks refer to a set of mathematical calculations that options traders use to evaluate risk. These include delta, gamma, theta, and vega. Failing to understand these calculations can lead to poor trading decisions and unnecessary risks.
What are the Greeks?
In options trading, “Greeks” are measures of an option’s sensitivity to various factors, such as changes in the underlying asset price, volatility, time decay, and interest rates. Traders use these measures to assess and manage risk in their options positions. The most used Greeks are delta, gamma, theta, and vega.
Delta measures the option’s sensitivity to changes in the underlying asset price, gamma measures the rate of change of delta, theta measures the time decay of the option’s value, and vega measures the option’s sensitivity to changes in implied volatility.
Overcomplicating your trades
Options trading can be complex, but that doesn’t mean you need to make it more complicated than it needs to be. Stick to simple strategies that you understand and feel comfortable with. Trying to get too fancy with your trades can lead to confusion and mistakes.
How to simplify your option trades
Before you try complex options strategies, make sure you have a good understanding of the basics of options trading. Learn about call and put options, their pricing, and the various factors that affect their value. Then, choose a few strategies that you understand well and feel comfortable executing.
On top of that, some options trading platforms have a wide range of tools that can be used to evaluate the market and place trades. However, using too many tools can be overwhelming. Stick to a few simple tools that you’re comfortable with.
Being too emotional
Options trading can be stressful, but it’s important to keep your emotions in check. Making decisions based on fear, greed, or other emotions can lead to poor choices and costly mistakes. Always stick to your plan and avoid making impulsive trades.
Keeping your emotions in check
To keep your cool when trading, you should develop a trading plan. Having a well-defined plan that includes entry and exit points, risk management strategies, and other important details can help you stick to your strategy and avoid making impulsive decisions based on emotions.
You should also set realistic goals that you can attain, and you should take regular breaks to clear your mind should you need it. On top of that, it may be helpful for you to participate in mindfulness practice. This can include deep breathing and meditation, which can help you stay focused and calm when making trading decisions. Finally, manage your risk by doing a thorough risk assessment for each trade before you open any positions.
Finally, one of the biggest mistakes options traders make is overtrading. This means making too many trades, often based on impulse or emotion, rather than sticking to a well-thought-out plan. Overtrading can lead to losses, as well as additional fees and commissions.
How to avoid overtrading
If you want to make sure you trade responsibly, a trading plan in place can help you stay disciplined and avoid impulsive trades. You may also want to limit your trading by setting a maximum number of trades per day or week and sticking to it, taking necessary breaks as your body and mind demand.
Many traders overtrade because they enact revenge trading. If you experience losses, it’s important to avoid making impulsive trades to recoup your losses. And finally, this may be difficult for some traders to believe, but sometimes the best trade is no trade at all. Therefore, it’s important to wait for the right opportunities and not force trades that are not there.
The bottom line
Options trading can be a good way to find opportunities in the markets. However, they are not for everyone, and there are common mistakes that end up being costly. By following the tips mentioned above, you can help avoid the pitfalls of overtrading and become a more disciplined and potentially successful trader.