One of the lessons that every trader must learn early is that success isn’t always about hitting the highest highs. The best traders avoid the lowest lows, and know how to protect themselves against losses, whether that means understanding their psychology, hedging or using options the way they’re meant to be used: to mitigate risk. Whether you’re testing an option trading strategy or looking for option trading tools, you’ll need to work up the discipline to avoid expensive mistakes. Here’s how.
Avoid low-volume options. How do you know if option volume is too low? Look at the little number next to the word “volume,” duh. But seriously, check the spread. A wide bid/ask spread is a sure sign that there’s not a robust market for the option, so when you go to sell, there’s no telling how much buyers will pay — if there are any buyers at all. How wide is wide? It depends. On cheap options, a $.20 spread can be suspicious, while a $20 spread might turn heads on a more expensive option.
Don’t bother with penny options. Options priced at $.10 or less can seem tempting. They’re like lottery tickets: cheap, plentiful, and soon to be worthless. But they’re always cheap for a reason, whether because they’re about to expire (more on that later) or just so far out of the money (OTM) that they exist only to tempt options newbies. And if the inherent risks aren’t enough, keep in mind that almost all brokerages still charge fees to trade options. Since these fees are usually charged when you buy and sell, a few cents per contract can easily eat up small gains.
Don’t experiment with close-dated OTM options. Options expiring in less than a month might look interesting. After all, if you have a strong feeling for where the stock’s going, this gives you some wiggle room that just buying the underlying stock itself wouldn’t give you, right? Wrong. Theta crush – also known as theta decay – is lurking. While the full details are a bit more complicated, theta is basically the bane of every poorly planned short-term option play. It’s the time value of the option, which (almost always) decreases in value as expiration approaches. Theta crush is real, it’s always waiting, and it couldn’t care less about you.
Don’t buy LEAPS without checking the calendar. Option trading, even more so than stock, commodity or forex trading, is a matter of time and momentum. If you buy LEAPS – Long-Term Equity Anticipation Securities, i.e., options with more than one year until expiration – you’re along for the ride. Like a barnacle on a giant publicly traded whale, you’re going to have to brace for whatever your host goes through or else get shaken off when times get rough. So, don’t just buy all Free Willy-nilly. Apprise yourself of key dates in the near future: earnings reports, peak sales seasons, fiscal year-end dates, major product launches, acquisitions. It all can have an impact.
All too often, options are for the trader who has run out of options. Is it bitterly ironic? Yes. Do we feel bad for the trader? Of course. Do we still secretly think “That would never happen to me!”? Every last one of us.
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