Option trade advice

Five Mistakes to Avoid When Trading Options.

(Especially since after reading this, you'll have no excuse for.

We’re all creatures of habit — but some habits are worth breaking. Option traders of every level tend to make the same mistakes over and over again. And the sad part is, most of these mistakes could have been easily avoided.

In addition to all the other pitfalls mentioned in this site, here are five more common mistakes you need to avoid. After all, trading options isn’t easy. So why make it harder than it needs to be?

MISTAKE 1: Not having a defined exit plan.

You’ve probably heard this one a million times before. When trading options, just as when you’re trading stocks, it’s critical to control your emotions. That doesn’t necessarily mean you need to have ice flowing through your veins, or that you need to swallow your every fear in a superhuman way.

It’s much simpler than that: Always have a plan to work, and always work your plan. And no matter what your emotions are telling you to do, don’t deviate from it.

How you can trade smarter.

Planning your exit isn’t just about minimizing loss on the downside if things go wrong. You should have an exit plan, period – even when a trade is going your way. You need to choose your upside exit point and downside exit point in advance.

But it’s important to keep in mind, with options you need more than upside and downside price targets. You also need to plan the time frame for each exit.

Remember: Options are a decaying asset. And that rate of decay accelerates as your expiration date approaches. So if you’re long a call or put and the move you predicted doesn’t happen within the time period expected, get out and move on to the next trade.

Time decay doesn’t always have to hurt you, of course. When you sell options without owning them, you’re putting time decay to work for you. In other words, you’re successful if time decay erodes the option’s price, and you get to keep the premium received for the sale. But keep in mind this premium is your maximum profit if you’re short a call or put. The flipside is that you are exposed to potentially substantial risk if the trade goes awry.

The bottom line is: You must have a plan to get out of any trade no matter what kind of strategy you’re running, or whether it’s a winner or a loser. Don't wait around on profitable trades because you're greedy, or stay way too long in losers because you’re hoping the trade will move back in your favor.

What if you get out too early and leave some upside on the table?

This is the classic trader’s worry, and it’s often used as a rationale for not sticking with an original plan. Here’s the best counterargument we can think of: What if you profit more consistently, reduce your incidence of losses, and sleep better at night?

Trading with a plan helps you establish more successful patterns of trading and keeps your worries more in check. Sure, trading can be exciting, but it’s not about one-hit wonders. And it shouldn’t be about getting ulcers from worry, either. So make your plan in advance, and then stick to it like super glue.

MISTAKE 2: Trying to make up for past losses by “doubling up”

Traders always have their ironclad rules: “I’d never buy really out-of-the-money options,” or “I’d never sell in-the-money options.” But it’s funny how these absolutes seem obvious — until you find yourself in a trade that’s moved against you.

We’ve all been there. Facing a scenario where a trade does precisely the opposite of what you expect, you’re often tempted to break all kinds of personal rules and simply keep on trading the same option you started with. In such cases, traders are often thinking, “Wouldn’t it be nice if the entire market was wrong, not me?”

As a stock trader, you’ve probably heard a justification for “doubling up to catch up”: if you liked the stock at 80 when you first bought it, you’ve got to love it at 50. So it can be tempting to buy more shares and lower the net cost basis on the trade. Be wary, though: What can sometimes make sense for stocks oftentimes does not fly in the options world.

How you can trade smarter.

“Doubling up” on an options strategy almost never works. Options are derivatives, which means their prices don’t move the same way or even have the same properties as the underlying stock.

Although doubling up can lower your per-contract cost basis for the entire position, it usually just compounds your risk. So when a trade goes south and you’re contemplating the previously unthinkable, just step back and ask yourself: “If I didn’t already have a position in place, is this a trade I would make?” If the answer is no, then don’t do it.

Close the trade, cut your losses, and find a different opportunity that makes sense now. Options offer great possibilities for leverage using relatively low capital, but they can blow up quickly if you keep digging yourself deeper. It’s a much wiser move to accept a loss now instead of setting yourself up for a bigger catastrophe later.

MISTAKE 3: Trading illiquid options.

When you get a quote for any option in the marketplace, you’ll notice a difference between the bid price (how much someone is willing to pay for an option) and the ask price (how much someone is willing to sell an option for).

Oftentimes, the bid price and the ask price do not reflect what the option is really worth. The “real” value of the option will actually be somewhere near the middle of the bid and ask. And just how far the bid and ask prices deviate from the real value of the option depends on the option’s liquidity.

“Liquidity” in the market means there are active buyers and sellers at all times, with heavy competition to fill transactions. This activity drives the bid and ask prices of stocks and options closer together.

The market for stocks is generally more liquid than their related options markets. That’s because stock traders are all trading just one stock, whereas people trading options on a given stock have a plethora of contracts to choose from, with different strike prices and different expiration dates.

At-the-money and near-the-money options with near-term expiration are usually the most liquid. So the spread between the bid and ask prices should be narrower than other options traded on the same stock. As your strike price gets further away from the at-the-money strike and / or the expiration date gets further into the future, options will usually be less and less liquid. Consequently, the spread between the bid and ask prices will usually be wider.

Illiquidity in the options market becomes an even more serious issue when you’re dealing with illiquid stocks. After all, if the stock is inactive, the options will probably be even more inactive, and the bid-ask spread will be even wider.

Imagine you’re about to trade an illiquid option that has a bid price of $2.00 and an ask price of $2.25. That 25-cent difference might not seem like a lot of money to you. In fact, you might not even bend over to pick up a quarter if you saw one in the street. But for a $2.00 option position, 25 cents is a full 12.5% of the price!

Imagine sacrificing 12.5% of any other investment right off the bat. Not too appealing, is it?

How you can trade smarter.

First of all, it makes sense to trade options on stocks with high liquidity in the market. A stock that trades fewer than 1,000,000 shares a day is usually considered illiquid. So options traded on that stock will most likely be illiquid too.

When you’re trading, you might want to start by looking at options with open interest of at least 50 times the number of contacts you want to trade. For example, if you’re trading 10 contracts, your minimum acceptable liquidity should be 10 x 50, or an open interest of at least 500 contracts.

Obviously, the greater the volume on an option contract, the closer the bid-ask spread is likely to be. Remember to do the math and make sure the width of the spread isn’t eating up too much of your initial investment. Because while the numbers may seem insignificant at first, in the long run they can really add up.

Instead of trading illiquid options on companies like Joe’s Tree Cutting Service, you might as well trade the stock instead. There are plenty of liquid stocks out there with opportunities to trade options on them.

MISTAKE 4: Waiting too long to buy back short strategies.

We can boil this mistake down to one piece of advice: Always be ready and willing to buy back short strategies early. When a trade is going your way, it can be easy to rest on your laurels and assume it will continue to do so. But remember, this will not always be the case. A trade that’s working in your favor can just as easily turn south.

There are a million excuses traders give themselves for waiting too long to buy back options they’ve sold: “I’m betting the contract will expire worthless.” “I don’t want to pay the commission to get out of the position.” “I’m hoping to eke just a little more profit out of the trade”… the list goes on and on.

How you can trade smarter.

If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Don’t be cheap.

Here's a good rule-of-thumb: if you can keep 80% or more of your initial gain from the sale of an option, consider buying it back immediately. Otherwise, one of these days a short option will come back and bite you when you’ve waited too long to close your position.

For example, if you sold a short strategy for $1.00 and you can buy it back for 20 cents a week before expiration, you should jump on the opportunity. Very rarely will it be worth an extra week of risk just to hang onto a measly 20 cents.

This is also the case with higher-dollar trades, but the rule can be harder to stick to. If you sold a strategy for $5.00 and it would cost $1.00 to close, it can be even more tempting to stay in your position. But think about the risk / reward. Option trades can go south in a hurry. So by spending the 20% to close out trades and manage your risk, you can save yourself many painful slaps to the forehead.

MISTAKE 5: Legging into spread trades.

“Legging in” is when you enter the different legs of a multi-leg trade one at a time. If you’re trading a long call spread, for example, you might be tempted to buy the long call first and then try to time the sale of the short call with an uptick in the stock price to squeeze another nickel or two out of the second leg.

However, oftentimes the market will downtick instead, and you won’t be able to pull off your spread at all. Now you’re stuck with a long call with no way to hedge your risk.

How you can trade smarter.

Every trader has legged into spreads before — but don't learn your lesson the hard way. Always enter a spread as a single trade. It’s just foolish to take on extra market risk needlessly.

When you use Ally Invest’s spread trading screen, you can be sure all legs of your trade are sent to market simultaneously, and we won’t execute your spread unless we can achieve the net debit or credit you’re looking for. It’s simply a smarter way to execute your strategy and avoid any extra risk.

(Just keep in mind that multi-leg strategies are subject to additional risks and multiple commissions and may be subject to particular tax consequences. Please consult with your tax advisor prior to engaging in these strategies.)

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Learn trading tips & strategies.

from Ally Invest’s experts.

Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.

Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. You alone are responsible for evaluating the merits and risks associated with the use of Ally Invest’s systems, services or products. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

Securities offered through Ally Invest Securities, LLC. MemberВ FINRAВ andВ SIPC. Ally Invest Securities, LLC is a wholly owned subsidiary of Ally Financial Inc.

9 Easy Tips for Option Trading Success.

Most investors who are looking for ‘tips’ for option trading success have the wrong perspective. They seek tricks, special strategies, or ‘can’t-miss’ gimmicks. There are no such things.

Options are the best investment vehicles around. They allow investors to take long, short, or neutral positions. They allow you to manage risk far better than any other investment method. Use them wisely and they will treat you well.

Option Trading Success Tips.

Here are nine easy tips for new options traders to follow if they want to be successful.

1. Options are best used as risk-reducing investment tools, not instruments for gambling. (Read my article, why trade options?)

3. Manage risk carefully. Do not hold any position than can – in the worst case scenario – cost more than you are willing to lose.

4. Be careful about the number of option contracts you trade. It’s easy to over-trade with inexpensive option contracts – especially when selling.

5. Don’t go broke. Never allow an unexpected event to wipe out your account.

6. Do not expect miracles. Do not buy options that are far out of the money just because they are ‘cheap.’ The chances of success are tiny. Not zero, just tiny.

7. Selling naked options is less risky than buying stock. But, like stock ownership, there is considerable downside risk. Exception: It’s reasonable to sell naked puts – but only if you want to buy the shares, if assigned an exercise notice.

8. Limit losses. The most effective way to accomplish that is to buy one option for every option you sell. That means selling spreads, rather than naked options.

9. Hope is not a strategy. When a position goes bad, consider reducing risk. Doing nothing and hoping for a good outcome is nothing more than gambling.

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Top 10 Option Trading Tips.

Option Trading Tip #1.

My top 10 call and put option trading tips that I have learned, and that you MUST know before you start trading calls and puts.

Trading Options Tip #1:

A stock price can move in 3 directions:

Most beginning option traders think that stock prices will either go up or go down, but they would be wrong! There is a third direction that stock prices move that is extremely important for call and put traders. Option traders must remember that that sometimes stock prices don't move up or down at all and that they can stay the same or remain in a narrow trading range.

Look at the chart below and you will see that for the last 23 days this stock's price remained mostly unchanged. Had you bought call options (expecting a bounce) or put options (expecting the continued decline) you probably would have lost your money!

So don't think you have a 50% chance of making a profit when you buy a call or a put option. It's more like 33%. That's because if stock price movements are random you will find that 1/3 of the time the stock price goes down, 1/3 of the time the stock price goes up, and 1/3 of the time the stock price remain flat or stays almost unchanged. In fact, when you are long a call or put option, time is your worst enemy. Each day that goes by your option is losing value since the chance that the stock price will move in the direction you want it to move is diminishing.

When you buy a call option, you are betting the stock price will go up. Sometimes the price will go up and you will have a profitable trade. But sometimes the price goes down, and sometimes the price just stays the same. If the price goes down or just stays the same and you bought an out-of-the-money call, then your option will expire worthless and you lose all of your money. If the price just stays the same and you bought an in-the-money call, then you will at least get your intrinsic value (or your in-the-money amount) back.

Sometimes the most frustrating thing about buying call call option is watching the stock price sky rocket the week after your option expired. In this case you will learn that you didn't give your strategy enough time. I have bought many call options that expire in the current month, only to see my stock stay flat and then rocket up AFTER my call option expired. That's the risk that you take buying a near month option and not a longer term option. That's also the reason the longer the term of the option the more costly the option will be.

Because of this concept that stock prices move in 3 directions, it supports the general claim that 70% of option traders that are long call and put options lose money. This means that 70% of option sellers make money. This is what drives a lot of the more conservative option traders from the strategy of buying call and put options to selling or writing covered calls and puts. Keep reading my next tip that you must study a stock's chart before buying call or put options.

Here are the top 10 option concepts you should understand before making your first real trade:

Options Resources and Links.

Options trade on the Chicago Board of Options Exchange and the prices are reported by the Option Pricing Reporting Authority (OPRA):

The Best Options Trading Advice: Don’t!

52 % of people found this article helpful.

Options trading can be very alluring for individual, non-professional investors. For the aggressive and risk-seeking trader, it is a chance to make a large multiple of your money if your view on a particular stock, exchange-traded fund (ETF) or index is correct. For the more conservative and income oriented, covered calls are a popular way to try to generate income on stock holdings. Whatever your style, here is a harsh but necessary reality check for all of you out there looking to dabble in options trading - just don’t do it.

There is a multi-billion dollar industry dedicated to profiting from retail investors who dabble in options trading (retail meaning individual, non-professional investors). I used to work at a market maker firm that systematically profits by taking the opposite side of less-informed people’s options trades. The founders of the firm are billionaires and super smart. They are the sharks in the water. You are the minnow. (For more, see: Getting Acquainted With Options Trading .)

A Speculative Bet.

Options trading is by definition zero sum. Any options trade is a speculative bet between two counterparties where one side wins and the other must lose in equal and opposite amount. It is not like investing in the stock market where many people, broadly, can participate in overall economic growth and everyone can win all together. In options trading, wealth is directly transferred from the dumb to the smart, from the poorly capitalized to the well heeled, and from the common speculator to the professional market maker.

Options trading is entirely a game about information. No one knows the future (except of course those who break the law and insider trade on stocks). Options traders must collect as much information as they possibly can (legally) and then make an informed but still speculative decision about what trade to place. The overwhelming advantage that the major market-making firms have over retail investors is that they are aggregators of massive amounts of information and trading flow and have lightning-fast technology to adapt and change their price.

They see every trade in every option in the markets in which they are buying and selling. Think of them as the Vegas bookmakers setting the line for an NFL game. Their job is to aggregate bets and set the point spread to exactly the right number. Almost no one is a long-term winner in sports betting. The only winner is the house. Options market makers are the equivalent of the house.

Even covered call writing, which is of course the most conservative form of options trading, is not going to add value for you over time. You may think you are enhancing your income on your stock holdings, but you will have your gains truncated in a bull market and still lose a lot in a bear market. And the more speculative options strategies are basically pure gambling - specifically, gambling against some of the smartest sharks in financial markets, which is a recipe for losing money quickly. (For more, see: Stock Options: What's Price Got to Do With It? )

Besides the information disadvantage against more informed market makers, there are additional costs to options trading. For one, there are brokerage commissions. For another, there is usually a substantial bid-ask spread. The market makers earn their living buying on the bid price, selling on the ask, trading a high volume of options, and having it all average out to a profit in the end. In regular, non-IRA brokerage accounts, options premium collected is subject to short-term capital gains tax. All in all, there is simply no edge for retail investors. Over time, option trading is a value-destroying behavior.

Some people simply enjoy the gamesmanship and the fast-paced competition of options trading. It’s almost like a hobby. They may delude themselves into thinking that they can be long-term winners. It is the same fantasy shared by the regulars at the track who bet the ponies or the people who bet NFL games. I suppose there is entertainment value to it, but if you are serious about making and keeping the most possible amount of money in your own pocket, you will simply avoid the options "casino."

Diversification.

In contrast to options trading, which is pretty much geared so that retail traders will lose, investing in a diversified portfolio of stocks and bonds is very much skewed in favor of the individual investor. These days, with the emergence of low-cost index funds and brokerage commissions and fees as low as they are, it is even more advantageous for individual investors. Earning a stream of dividends from stocks and interest from bonds and patiently sitting with a diversified portfolio for a long period of time is a game we can all win at together. (For more, see: The Importance of Diversification .)