TRADING
Avoid These Beginner Options Trading Mistakes
I made them, so you don’t have to.
Options trading serves me well these days, but it was a bumpy road at first.
And a lot of those early losses were avoidable…had I known what I know now.
Here are four of the most valuable ideas and tips I wish I’d internalized sooner.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
I’ve got an IV crush on you
“That one’s gonna go crazy after earnings! I’m loading up on calls!”
We all make that mistake, but I hope only once.
It’s true that either a call or a put — not both — will increase in value if the stock does “something crazy.” However, we’re probably not the first person to anticipate a huge price swing, so the magnitude and likelihood of that move are already priced in.
And there’s the rub: it’s all relative to expectations. The expected move is higher following earnings, so the threshold for a crazy move is higher, too.
Let’s get more concrete with an example from Nike’s (NKE) options chain.
See how implied volatility nearly doubles for the expiration cycle right after earnings, then promptly drops off?
The market already expects a move of up to $8.85 in either direction (that’s the number in parentheses).
Compared to NKE’s normal variation of a few bucks per week, that’s a lot…but that expectation is already priced in. Unless the move is even more dramatic yet, the contract you bought is likelier to lose value than to gain it.
Time heals all wounds (except options losses)
The most fundamental difference between options and shares is that options decay in value.
Obviously, there are other critical factors like leverage and the effect of volatility.
But time decay is perhaps the least intuitive yet most important for new traders to keep sight of.
That’s because you risk losing money even if the stock doesn’t move against you.
For instance, let’s say XYZ trades at $50.00/share. I buy the $48.00 call for a premium of $2.45. A couple days pass, XYZ is still hovering around $50.00/share, and my call is now worth $2.35.
I lose $0.10 in premium (so, $10.00) even though XYZ hasn’t move against me!
But what has moved against me is time.
The call is still $2.00 in the money, so the intrinsic value of $2.00 did not change. But its extrinsic value — think of it as the insurance value — decreased by $0.10 as time passed.
Fewer days remaining → fewer chances for extreme events → lower premium.
Bottom line:
- When buying shares, you’ll profit if you’re right about the direction of price changes.
- When buying options, you’ll profit if you’re right about the direction and timing of price changes.
If you’re not comfortable attaching a deadline to your prediction, then don’t open a long options position!
(Or consider selling rather than buying options. That creates other risks, but it does generally profit from time decay rather than lose to it.)
Get your fill
Early on, I’d get impatient. I wanted a quick fill, so I repeatedly left money on the table when opening and when closing.
As a newbie trading small but frequently, this undermined a large percentage of my profits. It was like a self-imposed commission.
So, what should you do instead?
Unless you’re a big hurry — we’re talking a get-me-out-of-this-position-now-or-else! sort of hurry — it’s wise to enter a limit order that’s a couple pennies more favorable than the suggested mid price.
Say the bid is $0.60, the ask is $0.70, and my brokerage suggests a mid price of $0.65. If I’m buying the contract, I’ll start at perhaps $0.63 and wait a few minutes. If I’m selling, I might start at $0.67.
If no fill, then I’ll move a penny or two closer to the mid.
But quite often it does fill, which boosts my gains (or mitigates my losses) by another 1–2% points or more.
Unless there’s a hair-on-fire degree of urgency, it pays to be patient.
“Sixty percent of the time, it works every time”
Finally, a subtle but critical distinction that might not sink in right away.
High win rates aren’t necessarily profitable.
If you win a certain amount 99% of the time, but lose 1000x as much just 1% of the time, then you’re still irrecoverably down.
The better question to ask is this: “What’s the expected value of my strategy?”
The math is simple enough: win rate * upside + (1 — win rate) * downside.
What’s harder is keeping this level-headed, detached rationality to every decision. More like poker and less like a slot machine, if you will.
Admittedly, expected value has a built-in assumption of “all else being equal.” That doesn’t always apply, so discretion and experience do have a role.
But when expected value is your starting point, plus you know your downside in extreme scenarios (so-called tail risk), you’re on the track to prudent, defensible, and probably profitable choices.
While profits are never certain, you can stack the deck in your favor by avoiding these common pitfalls.
Even so, there’s no teacher like learning the hard way. Don’t beat yourself up when reasonable risks don’t work out in your favor…but do stop to examine the assumptions that led you there.
Start small, stay humble, and keep learning at every step along the way.
