Thursday, 17 September 2015

How to Avoid the Top 5 Mistakes New Option Traders Make

1: Starting out by buying out-of-the-money (OTM) call options

It seems like a good place to start: buy a call option and see if you can pick a winner. Buying calls may feel safe because it matches the pattern you’re used to following as an equity trader: buy low, sell high. Many veteran equities traders began and learned to profit in the same way.

2: Using an “all-purpose” strategy in all market conditions

Option trading is remarkably flexible. It can enable you to trade effectively in all kinds of market conditions. But you can only take advantage of this flexibility if you stay open to learning new strategies.Buying spreads offers a great way to capitalize on different market conditions. When you buy a spread it is also known as a “long spread” position. All new options traders should familiarize themselves with the possibilities of spreads, so you can begin to recognize the right conditions to use them.

3: Not having a definite exit plan prior to expiration

You’ve heard it a million times before. In trading options, just like stocks, it’s critical to control your emotions. This doesn’t mean swallowing your every fear in a super-human way. It’s much simpler than that: have a plan to work, and work your plan.
Planning your exit isn’t just about minimizing loss on the downside. You should have an exit plan, period – even when things are going your way. You need to choose in advance your upside exit point and your downside exit point, as well as your timeframes for each exit.

4: Compromising your risk tolerance to make up for past losses by “doubling up”

I’ve heard many option traders say they would never do something: “…never buy really out-of-the-money options!”, “…never sell in-the-money options!” It’s funny how these absolutes seem silly – until you find yourself in a trade that’s moved against you.
All seasoned options traders have been there. Facing this scenario, you’re often tempted to break all kinds of personal rules, simply to keep on trading the same option you started with. Wouldn’t it be nicer if the entire market was wrong, not you?
As a stock trader, you’ve probably heard a similar justification for “doubling up to catch up”: if you liked the stock at 80 when you bought it, you’ve got to love it at 50. It can be tempting to buy more and lower the net cost basis on the trade.

5: Trading liquid options

Simply put, liquidity is all about how quickly a trader can buy or sell something without causing a significant price movement. A liquid market is one with ready, active buyers and sellers at all times.
Here’s another, more mathematically elegant way to think about it: Liquidity refers to the probability that the next trade will be executed at a price equal to the last one.

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