3 Option Trading mistakes & avoidance techniques

Option Trading is convenient yet a bit complex game. However, I sincerely feel that if a trader is rule driven and disciplined then the complexity goes away.

Let me define top 3 mistakes that an Option Trader would do. Mistake here can be looked as more of a “miss” than wrongdoing. However, outcome of loss will always make it look like a mistake.

Getting down to business. 3 aspects of Option Trading generate these mistakes. Let us look at each one of them closely. Once understood the solution will be easy to identify.

1. Wrong Option to Buy (Strike Selection):

Any wise trader will always chase cheapest deal to Buy. However, just like many consumables cheapest is not always the best in Options. Let us say one Buys very higher strike Call Option or lower strike Put Option (when compared to current market price of the stock/index). Outcome is very small profit on the Option trade even if the bullish or bearish move does fold out as expected. This creates frustration because most of the times the transaction costs would be bigger than the profits.

Mistake: Higher Strike Calls and Lower Strike Puts are less sensitive to the movement in the stock/index than the closer strikes. Due to this despite of the accuracy of the view on the stock/index, one does not make good money.

Solution: Try not to Buy beyond 2-3 strikes higher in terms of a Call or 2-3 strikes lower in terms of a Put.

2. Unprotected Options Selling:

Option Selling is a trade where one is exposed to unknown and a very big loss while the maximum profit is just the premium received. Any Option sold in isolation will have such risk exposure and thereby can be called unprotected. Should we not sell Options in isolation at all? In my opinion for trading, it is advisable not to. There are traders who use Options selling to add or exit their investment exposure using Option Selling, that is fine to be unprotected.

Mistake: Relying on stop loss driven Option Selling and not providing for a possibility of a very big loss in case of a sudden gap up or gap down. Here just one out of 10 trades need to go wrong to put us out of business.

Solution: For every call sold, Buy a higher strike Call (with lower premium). Likewise, for every Put sold, buy a lower strike Put. This will reduce premium received but will also reduce margin. Lastly, the max loss will be limited to difference between bought and sold strikes.

3. Trading Option Like Lottery:

We have come a long way but still few times we do trade Options like Lottery ticket. If the stock moves anytime during expiry, then we will make money else, we make accommodation for losing the entire premium.

Mistake: Not having an exit strategy attached to bought Options. We carry unnecessary position.

Solution: Trade Options like any other stock. Keep a target and keep a stop loss along with a time stop loss. Remember, premium also reduces due to passage of time.