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Due to its capacity to generate excellent returns with minimal capital as well as a method to hedge against market volatility, options trading has been progressively growing in popularity. However, options trading is fundamentally quite risky and, if done improperly without good strategies or knowledge, can result in significant losses. These losses have the potential to wipe out the investor’s whole fortune. Even though making mistakes is an important part of developing knowledge and confidence, beginners who are trading options should nonetheless look for measures to reduce them to protect their portfolios.
options trading Mistakes to avoid
5 Common Options Trading Mistakes To Avoid as a Beginner Trader
Here is a list of some of the most frequent mistakes that people new to option trading tend to make.
1. Not Having a well-defined exit plan
Not developing a solid exit strategy is one of the most common options trading mistakes that beginner traders make. For options trading, emotional control is essential, and traders should always be prepared with an exit strategy they can implement no matter what the circumstances are. This is owing to the fact that trading plans will help in the development of more lucrative trading patterns while also managing fears.
Moreover, the aim of exit strategies is not just to reduce losses in the event that a trade goes sour. Even when a trade is going one’s way, it is still necessary to have a plan for exiting it. In essence, one must always choose both the upside and downside exit points well in advance. Additionally, one should avoid staying too long in losing trades in the hopes that the deal would turn around because doing so exposes them to significant risks of the trade going further wrong. Similarly, there is no purpose in waiting around on lucrative trades out of greed.
Related: Ultimate List Of The Top 9 Options Trading Alerts Services Right Now
2. Buying Out-of-the-Money (OTM) Call Options
OTM call options may seem like a great buy during the initial years of one’s trading journeys because of the lower cost involvement. One may always try to look out for an option that is cheap hoping it to turn into a winner just like the pattern one follows in stock trading i.e buying cheap and selling high. However, this kind of approach doesn’t work that well for options trades often and if someone limits themselves to only this strategy, they might lose more money than they make a profit.
So, it will be more reasonable to consider selling an OTM call option on a stock that the trader already owns because by doing this they will be resorting to the covered call strategy that can help them earn more funds in a sustainable manner in the long run. One should also keep in mind that the risk of owning the stock can be substantial.
Related: Top 29 Best Options Trading Books You Need to Read Right Now
3. Doubling up in an effort to make up for previous losses
Even though many traders have criteria like “I’d never buy truly out-of-the-money options” or “I’d never sell in-the-money options,” they nonetheless end up in trades that go against them. It tempts traders to breach all types of personal rules and simply continue trading the same option with which they started when they encounter a situation where the trading results are completely contrary to what was anticipated from it.
In the options market, the “doubling up to catch up” concept does not hold as well as in the case of stocks. Options are a form of derivatives and their prices don’t move the same way nor do they have the same properties as in the case of the underlying stocks. Further, although doubling up can lower the per-contract cost basis for the entire position, it usually just compounds the overall risk. Therefore, it would always be beneficial to close the trade and cut down the losses by accepting the losses instead of setting yourself up for a bigger catastrophe later.
Related: Beginners Guide: Put Options And How To Trade Them With Put Options Example
4. Trading illiquid options
How rapidly an item may be bought or sold without significantly changing its price determines how liquid that item is. Usually, a liquid market means that there are always willing and able buyers and sellers. In general, the stock market is far more liquid than the options market, mainly because stock traders are only trading with one stock, but options traders may have thousands of options contracts to choose from.
Liquidity problems in most cases won’t occur for large, highly liquid equities or their options. However, the issue arises with smaller equities that trade less frequently, such as once a week, because the options on them are typically far more likely to be illiquid than the stocks. Therefore, everyone who wishes to trade options should make sure that the open interest is at least 40 times the number of contacts they intend to trade.
5. Legging into spread trades
In order to squeeze an extra nickel or two out of the second leg of a long call spread, for instance, a trader would be tempted to purchase the long call first before attempting to time the sale of the short call with an increase in the stock price. Unfortunately, at many times the market actually declines instead, making it impossible to execute spreads at all.
Many traders engage in this behavior under the false impression that they are reducing risk, while in fact, they are taking on excessive risk for an unfairly low payout. The optimum strategy will therefore be to enter a spread as a single trade without unnecessarily adding to the market risk.
Conclusion
Some of the most frequent errors that options trading beginners tend to make are those that are described above. We expect that after reading this post, traders will have a clearer understanding of the options trading mistakes they should strive to avoid when carrying out their trades. Further, in addition to the ones described above, there are also a number of other issues that one could encounter. So it is crucial to get proper knowledge via options trading books, videos, or courses and to conduct thorough research before putting any plan into practice.
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