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The Biggest Pitfalls Rookie Option Traders Make

Jan. 06, 2011 4:28 PM ET
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When an investor realizes the great leverage power of options and begins to dabble in them in their brokerage account or IRA, I've seen them make the same mistakes time and again.

I've been trading and analyzing options since the early-1990s and at BigTrends.com we've been educating and providing specific trade recommendations since 1999.  So we've seen it all, and have learned the most common mistakes traders make and the best ways to avoid those and get an "edge" over the markets.

1st — Those who are new to options are immediately attracted to the very cheap "lottery ticket" type Out-of-The-Money (OTM) options.

By this we mean the options that are priced at 0.25 ($25) or below, for example.  These are the OTM Calls and Puts that can potentially give very big gains, but have a low probability of success.  These options tend to have a very low Delta (which is an Option Greek that can be interpreted as a probability of the option expiring In-The-Money (ITM)).

Additionally these options have no "intrinsic value" and are 100% "time premium" — so you will lose value on the them due to time decay as the clock ticks towards expiration.  And you may also lose value due to decay in implied volatility (Vega option greek).

So we tend to prefer ITM options.  These generally have a lesser amount of time premium & implied volatility built into them and have a higher Delta — so basically you normally get more "bang for the buck" with an In-The-Money option.  Additionally your overall volatility should be less when trading these versus very cheap OTM options.

2nd — Traders enter positions without a gameplan, or specific targets and rules for taking profits and limiting losses.

Again, we've seen this time and again and all traders have done this at one time or another in their trading accounts.  Letting a winning trade turn into a loser, or letting a small moderate loser become a big loser.

This comes down to discipline and having a organized set of rules.  For example, if a trade doubles (goes up 100%), you may have a rule that you exit half of your position immediately, then you basically have a "free trade" on the remainder of your contracts.

You also could have specific targets for the underlying stock/ETF/security and when those are reached you exit part or all of your position, regardless of where the option price is.  Another valuable strategy is to have a trailing stop-loss for winning positions, so that you can stay in the winners and let them run, but if it pulls back by a certain amount you still lock in your profits.  Or you can have set rules such as taking partial profits at 25%, 50%, etc.

But the bottom line is that without having systems, rules, indicators, and discipline you are somewhat trading "blind".

And for the losing trades … we've all had them.  First, I've learned through experience that the best trades tend to go your way quickly.  If a "perfect" setup is just sitting there and not going your direction, it may be time to cut bait and move on to the next opportunity.

Next to the problem of "hope and wait" on losing trades (also known as "Hopeium"), this is how a small 15% or 20% loser can turn into a 50%, 75% or even 100% losing trade.  And those can put a big damper on your portfolio and create a trading hole that you then have to dig out of.

So limit your losses to small amounts.  The goal in general is to have winning trades be 2x to 3x the size of losing trades, depending on the win/loss ratio of your strategy.  Have rules and discipline in place on your option trades.  For example, have a specific stop-loss, or a technical indicator that when violated gives an immediate exit on the position. 

In general, having a clear trading plan with systems, rules, indicators and goals will provide more confident and successful trading results over the long run.

Trade Well,
Price Headley

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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