Mistakes to Avoid in Options Trading

Highlighted here are some of the key mistakes a trader makes in the option market which are pulling him down. 

WHAT MISTAKES TO AVOID WHILE TRADING OPTIONS?

Lack of understanding options: Many traders jump into options trading without really understanding the reasons behind the movement of options or the maths behind it. Little attention is paid to details like how much does an option move with respect to the underlying share or index.

Buying out-of-the-money options: Lack of understanding options results in retail traders buying options which are out of the money for the simple reason that they are cheap. An occasional win trade results in the trader getting fixated to buying out of the money options. In most cases even when the trader is right in his trade he loses money in the out-of-the-money trade since it requires a very sharp and fast move for these options to become profitable. It has been found out that trading in out of the money options is one of the biggest reasons for option trader loses.

Using one strategy that fits all: Option strategies are rarely understood and investors end up trading in vanilla call and put options and losing money in the process. These days many brokerages offer option trading strategies to choose from, making it easier for investors to select, but few investors utilize these services. 

Not having an exit plan: Traders lose money because they do not know when to exit from an option position even if they are right. The fact that holding on to a position as time passes, erodes the value of the option is rarely understood. Similarly since the amount involved in options is small traders do not trigger the stop losses. They tend to hold to the trade in the hope that a move in their direction will result in a profitable exit. Ones an option goes out of the money as the underlying stock or index moves away from it, it would require a big move for it to come back to its breakeven level. 

No clue of an event calendar: Option prices tend to over-react when an event is approaching. Investors read the rising value in options as a sign of a big move in its direction. Movement in option prices at the time of Infosys results announcement is the best example of how they rise without any appreciable rise in the underlying. Rising option prices is the premium that is being built in anticipation of a sharp move in either direction. 

Lack of understanding of time decay: Another big factor that plays against a retail trader is lack of understanding of time decay on option prices. For as option price to rise the underlying stock or index needs a move in line with the option bet and fast. A grinding move plays against the buyer of an option. As time passes options lose value faster. Many retail traders hold on to their trade or take new bets close to the expiry of the market, because option prices are cheaper during this period. But most trades close to the expiry period turn out to be losing ones, unfortunately a novice trader holds on to his position since the amount involved is small. It’s these seemingly small loses are what cause the most damage to a novice trader.