Three common mistakes options traders make

E*TRADE from Morgan Stanley


Working on building your options trading skills? You may want to consider three common mistakes options traders make—pitfalls that experienced traders try to avoid.

1. Price

The first mistake is having unrealistic price expectations, which can lead to buying options that aren't likely to be profitable.

Imagine a stock whose price has been trending up. Traders who overestimate how much the price of that stock will rise may be tempted to buy call options that are well out-of-the-money. After all, these options appear to be inexpensive. But the price of the stock must move past the strike price plus the premium paid, fees, and commissions in order for the trade to be profitable. That could be a tall order.

2. Time

A second common mistake involves time—traders may buy far too little of it. In other words, they buy options with expiration dates that are too short.

This can be a problem because the value of an option declines as its expiration date approaches, due to what’s known as theta, or time decay. This decline is not linear, it's exponential. As expiration gets closer, the rate of decay speeds up dramatically.

Here's a general rule of thumb: consider buying three times the duration you think you'll need for your trade. This could help reduce the effect of time decay on your position.

3. Quantity

One of the advantages of options is that they use leverage, letting traders gain exposure to a stock's price with less money than it would take to buy the stock outright. But leverage is a double-edged sword. It's possible to make a lot of money using it, but it's possible to lose a lot, too.

That's why it's so important to properly manage risk, and why it's a good idea to right-size your options positions. Owning too many options can tie up your capital and also exposes your portfolio to a larger loss if things don't go as you hoped.

Price. Time. Quantity. Understanding these important components of options trading can help you avoid common pitfalls. And that, in turn, can make you a better-informed investor.

What to read next...

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Looking to expand your financial knowledge?