Five Mistakes to Avoid with Options Trading

In the early 1900’s police would periodically arrest people for setting tolls on the Brooklyn Bridge, after the would-be toll setters had been duped into buying the bridge from George C. Parker in the first place. Tulips once overtook and then sank the entire Dutch economy. And, of course, the Shake Weight exists.

The point is, it is all too easy to make mistakes with money. That is true in day-to-day life, but it is even more the case when it comes to finance and trading. Options contracts are complicated enough. Here are five easy mistakes you do not have to make.

#1.  Trading your needs rather than the market.

Also called emotional investing, this is probably at the top of most do-not-do lists when it comes to your money.

Option contracts have a lot of flexibility. From setting the strike price to picking an expiration date, as the investor you can write your own check. The trouble is, if the market does not agree with you, that check will bounce…hard.

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Make your investments based on smart trading and what the data says, not based on how you would like your portfolio to pan out. Just because you want that money by next month does not mean the stock market will play ball. Speaking of which…

#2. Setting the wrong expiration date.

This is one of the easiest mistakes to make, especially for newcomers to the options scene, because expiration dates are one of the most unusual aspects of trading stock options. So be careful with them.

Expiration dates can be dangerous. It is far too easy to judge an expiration date based on a gut feeling, a billing cycle, or a whim. “Thirty days seems about fair” may sound like something you would never say, but just wait… it can happen before you know it.

Do not make that trade. Set your expiration dates based on hard data, not a best impression.

#3. Misunderstanding out-of-the-money contracts.

In-the-money contracts are your most solid investment vehicles. These are the contracts which, if executed at the moment of sale, would make some profit. They do not tend to make much money because the only difference between the price you pay and the rate of return is based on how long the seller thinks you will wait and how likely it is that the contract will go out of the money in that time.

So, many investors gravitate toward out-of-the-money contracts, the ones which currently do not have any value but which will, if the market makes a favorable change.

These are the most profitable, certainly, but also the most speculative. There is nothing wrong with making a few gambles, but do not overstate the role of out-of-the money contracts in your portfolio. The slow and steady money wins the retirement race.

Time is money, and make sure your time fits your money.

#4. Misunderstanding risk capital.

Speaking of taking bad risks, one of the worst mistakes in all of investing is to misunderstand risk capital and its role in your portfolio.

We have written about this subject in the past, but here it is in a nutshell. Some investments are stable, long term sources of steady growth. They get the retirement fund and the kids’ college money. Other investments, like stocks and most out-of-the-money options, are speculative. Anything can happen, which means you might hit it big or lose it all.

Those investments get money you can afford to lose.

#5. Trying to win back your money.

Do not double down on bad positions.

It is true that there are some parallels between investing and gambling, including the instinct to go deeper into a hole while trying to dig yourself out. For a gambler, this means staying at the table to try and win back money on the same game.

For an investor, it means throwing more money at a losing position to try and make up for past losses. Unless you have concrete information (see #1), do not put more money into bad positions. Know when it is time to cut your losses.

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