6 Mistakes to Avoid When Trading Option

(by Bryan Perry )

Your goal as an options trader is to move the odds in your favor wherever possible to ensure the success of your trades. Everyone likes to talk about their successes, but it's really the mistakes that teach us the most.

Even professional traders have taken a lot of lumps in their careers, so let's review some of the most common (read: most costly) mistakes that people make when trading options. I hope this will save you a lot of time, money and frustration as you embark on your options trading journey!

Don't trade willy-nilly--have a strategy for profits

Why do traders get into certain stocks (or their options)? Well ... most of them don't have any idea. And when you don't have any idea why you're getting in, you've got no edge and, thus, no strategy for getting out with profits.

Stocks are volatile and move for a number of different reasons. They are also impersonal -- meaning, they really don't care if you own them or not. For the most part, stocks will be around for a long, long time and can typically be closed whenever you want, for some value.

Meanwhile, options expire and these trades either win, lose or break even on your investment. Even though you should be playing the options game with your "funny" money -- i.e., what you can afford to lose -- many traders forget that they're still playing with real cash.

Options are much more volatile than stocks, so a strategy is especially critical, especially in unpredictable markets where the trading landscape changes in the blink of an eye and profits can quickly become losses.

Don't put too much money into one trade

Options are not long-term investments -- they are calculated tools that provide immense leverage. But, this leverage can work both ways, so make sure to never risk more in any one option trade that you wouldn't be OK with losing if the trade turned against you.

Remember, one option contract enables you to control 100 shares of the underlying stock, so even if a contract might cost $50, if you normally buy five or 10 contracts, you shouldn't buy 20 or 30.

It might seem like you're shopping at your favorite wholesale club, but if that trade turns against you, you're placing $1,500 at risk. That might not seem like a lot of money, but if you've shorted a call -- which gives the call buyer the right to purchase stock at the option's strike price -- and you aren't in possession of the underlying stock, you could find yourself scrambling to get 3,000 shares to turn around and sell.

Suddenly, that inexpensive option doesn't look so cheap anymore!

Don't overpay for overpriced options

Sometimes options can be priced just right. Other times they seem downright cheap, yet in some other situations they can be trading at a steep premium. How do you know if the "price is right" for a particular option?

Options can be an inexpensive way to play a big-name (and oftentimes big-ticket) stock, as one options contract that controls 100 shares of stock can seem like pocket change in comparison. However, you have to be extra-careful when volatility levels in the markets spike. Option premiums go up during these times but then pull back as investors gain more confidence.

When you pay too much for an option, it just takes a little adjustment to this volatility to whack the price down (even when the underlying stock doesn't move that much). Keep tabs on the Chicago Board Options Exchange's Volatility Index (VIX) and its Nasdaq Volatility Index (VXN) -- the higher the volatility numbers, the greater the fear out there and, thus, the higher the option premiums.

Reality check time --know how much stock you're really controlling

Always do a reality check and calculate how much stock you are really controlling when you initiate an option trade. If you buy 20 contracts, remember that you're actually controlling 2,000 shares of the underlying stock. If you would only normally take a 500-share position in a stock, then you should only buy five option contracts.

Some investors get carried away with options, and end up owning 50 or 100 contracts or more -- but don't realize that their investment can go to zero!

Don't wait too long to take profits

We're all in this game to make money and when we see our options trade move into-the-money (i.e., the market price of the stock exceeds the strike price of the option), we are excited by the possibilities. After all, making 100%, 200%, 300% or even higher gains is one of the many benefits of trading options, as a small investment really can go a long way.

But sometimes, folks aren't happy with their current gains and wait just in case there's more money to be made. Remember, the bigger the win, the more you can lose. Take some profits off the table while still leaving a portion of your position in the markets so you can take advantage of any additional upside that might be left in the trade.

If you preserve a portion of your winnings from the beginning (for example, if the trade doubles in value from your entry price and you cash out 50% of your holdings), you know you have a shot at more profits, but you're also protected in case the market or the stock melts down during the life of your contract.

Bottom line: When you're profitable, take money off the table and call it what it is: a trade!

Don't hope for the best -- plan your exit

There is one important question you need to address before ever getting into a trade: When am I going to get out?

As we discussed in No. 5, if your trade doubles in value, you can decide to take profits in half the position. But what if your trade goes down? You can set a sell stop (in the case of buying options) or a buy stop (in the case of selling them) from the outset so that if the position goes down a certain percentage, you're automatically taken out of the trade.

Many traders set a "mental" sell stop to head for the hills if their option loses half of its value. But it's just as easy to tell your broker the specific level at which the trade should be closed. That way, you don't make a decision based on emotion -- just because you "hope" a trade will recover.