Options Trading Mistakes to Avoid
Options trading can be an exciting and potentially lucrative endeavour – when done right. However, it is not always so simple. Many traders who wish to participate in the options market may find it difficult to achieve the discipline, flexibility, and knowledge that becoming a good trader requires.
In this article, we will discuss the common pitfalls of options trading for traders of all levels. If you are looking forward to starting your options trading journey, it is essential that you have a strong understanding of these potential mistakes and avoid them when you can. By recognising them, you can enhance your trading journey, protect your capital, and increase your chances of long-term success.
Without further ado, let’s explore the top options trading mistakes people make, and how they can be mitigated.
Trading without a plan
One of the most common options trading mistakes is to trade without first creating a plan. A trading plan is a document that outlines a trader’s goals, limits, risk boundaries, and strategy. Trading plans are essential as they can guide traders into making decisions that are calculated and informed, and they can be a good way for traders to understand their own parameters.
When traders decide to participate in the options market without first establishing a plan, they cannot track their progress and have no understanding of their objectives. This can easily lead to impulsive decisions or trades that go against the level of risk they can afford to take. Trading without a plan can also lead to emotional decision-making and lack of direction when investing.
The second mistake options traders make is overtrading. With a clearly defined plan, traders will have a solid understanding of how much or often they should be trading depending on their experience and time available.
Overtrading occurs when traders make excessive or impulsive trading decisions on a whim, which can lead to higher transaction costs, increased exposure to market risks, and a reduced focus on conducting quality trades. All of these can lead to more losses incurred for the trader from, potentially, investment decisions that were not carefully thought-through.
Not doing sufficient research on the market
Options are highly versatile. As a derivative instrument, traders can take part in different financial markets and speculate on the price fluctuations of various asset classes. However, it is precisely this versatility that can trip up traders – when they do not conduct sufficient research on each market before they purchase an option on an instrument.
Before trading, traders should know how the market works, such as its opening and closing hours (if there are any), its characteristics, its historical performance, and the performance of the specific instruments they wish to speculate on. This includes understanding what drives the prices of instruments and how. Traders who wish to have a more productive experience in the financial markets should do sufficient research on how to best approach the instrument and when to buy or sell.
Not doing sufficient research on options trading
Aside from not doing sufficient research on the financial markets on which they are speculating, some traders may also struggle with understanding options trading in the first place. Options are complex, and there are concepts and strategies that may be slightly more difficult than regular trading. When traders want to trade options, they should understand the mechanics of options, what contracts contain, what implied volatility is, what the Greeks are, and how strategies form and can be executed.
There are plenty of resources available online on options trading. They include guides and webinars, as well as articles on how to spot opportunities in the market. Traders should ensure they are educated on the derivative instrument and how the options market works before attempting to start trading.
Lack of risk management
Failing to consider risk is also a problem for many traders who get too caught up in trading and their attempts to capture profits. It is essential that traders understand what their own boundaries are, set clear risk parameters, and use the available risk management tools that are available for them on trading platforms.
Some risk management tools include stop-loss orders, portfolio diversification, and the marking up of chart patterns with indicators. Stop-loss orders are automatic orders that trigger the sale of an option contract if its underlying asset reaches a predetermined price level that is outside of the acceptable range set by the trader. Diversifying portfolios can be a great way to not put all of one’s eggs in one basket, while chart indicators such as the Fibonacci retracement levels, Bollinger Bands, and Moving Averages can help traders better forecast potential price movements.
A lack of risk management when trading can lead to increased losses, when traders do not manage to exit trades on time, or when they misread market conditions. Over time, these losses can add up, and it can be a real dent in a trader’s funds.
Having emotions when trading is a good thing, as it can lead to more care and thought being put in the investments and even more passion for the financial markets. However, it is important for traders to note what emotions they are experiencing and to limit negative ones like impulsiveness, fear, and greed.
Emotional decision-making occurs frequently among inexperienced traders in the options market. Experienced traders may also be susceptible to it, depending on market conditions. Emotions such as fear and greed can lead to traders overtrading or making irrational decisions. There is also the issue of acting on impulsiveness – when traders do not first conduct proper analysis on instruments, it can lead to unpleasant surprises and suboptimal trading outcomes.
Lack of adaptability
Finally, for seasoned and novice traders alike, there is also the problem of not being adaptable enough. While having a firm trading plan is good as it can bring some structure into traders’ schedules and plans, sticking too closely to plans may leave traders with no room for new ideas or to pivot when situations call for it.
There is also the issue of being ‘married’ to trades that many long-term traders may have. Some traders may feel sentimental about letting go of an instrument that has been on a downward spiral for a while, and others may want to persist trading their preferred instrument despite a too-volatile price history.
Financial markets are dynamic, and traders should understand that there are always unpredictable events unfolding that can cause market prices to change. Adapting their strategies is crucial. Traders should regularly review and refine their approaches and plans, so that they align with current market trends and volatility. This flexibility can allow traders to discover new opportunities and potentially benefit from them.
Traders should remember that we are only human, and mistakes are inevitable. We all make mistakes on our investment journey. The key is to be aware of these common mistakes and learn from them, and to take steps from preventing them from occurring as much as possible. For those who wish to learn more about trading and to become a better trader, they can always access materials online that discuss options trading and the financial markets, for them to learn more about the key concepts and terminology they may be unsure about.