Most of the business traders do not earn any profit, mostly in terms of options trade. Over 90% who traded options lost and could only wonder what they did wrong. The reason is that they do not know the essential parameters of options trade because some of them couldn’t get general concepts and therefore suffered from loss with frequent repetitions.
But if you are one of them, then it’s about time things change. Here in this article, we will discuss some reasons for which most traders fail, why they commit the same mistakes over and over again, and most importantly, how you could overcome those and initiate consistent profit generation with options trading. Let’s see the causes for this gigantic problem and the strategies that might just help you win at options trading.
Mistake #1: Buying Cheap Options and Forgetting About the Likelihood
The biggest mistake options traders do is buying cheap options with hopes of becoming a jackpot-winner with very little to lose. Cheap options seem like a good deal at times, but options are much more likely to expire worthless. The biggest problem comes about when the trader forgets that an option has a probability that it will arrive at its strike price.
Example
Let’s go on an example with Tesla. Now, if the price of Tesla trades at $181.02. You have your instinct and feel that it’ll keep going up. You buy a $205 strike price call option that was priced at $57 due for expiry in 11 days. On an intuitive level, it seems like a great deal-it’s cheap and provides incredible potential rewards if Tesla rises.
But this delta is 0.0830, so there’s a 91.7% chance the option will expire worthless. You’re right about the direction of Tesla. If the stock does not move over $205 by the end, you lose the entire premium.
Solution:
Never buy cheap options unless you know the chances for success. While it might be very tempting to buy options since they cost peanuts, in most cases, it is always low to make money on them. Sell them instead for premium income, especially if you feel that the odds are high that they are going to expire worthless. And if you do buy, be sure to manage your risk on these by taking in more protection through a credit spread.
Mistake 2: Underestimating the Cost of Timing and Direction
Another very common mistake options traders make is they downplay just how much of a big deal timing and direction may be in any given trade. Even if you’re right about the direction of the stock, if the stock’s not moving enough or fast enough, your options will expire worthless. Which again means you’re losing money.
Example:
Let’s roll back the clock to Tesla, except this time you are more confident that the stock is going to go up, so you buy a call option with a higher delta because of the higher strike price of $190 for 70 bucks. After 18 days your stock had gone over your strike price to $191.16, and you’re feeling positive.
You were right on the direction but wrong on the price move. At expiration, the option is worth $116, but you paid $370 for it, so you have a loss. You got the timing right and the direction, but stock just didn’t move enough to make the option pay off.
Solution
But when you buy options you do have to consider not just the direction of the move of the stock’s price, but the timing of the move. It isn’t enough that you predict a stock is going to rise—it has to go far enough as to pay back the option and therefore to make it profitable. If such a price movement seems unrealistic, selling the option or using a spread strategy to protect yourself is going to be a better play.
Mistake 3: Lack of Knowledge on Implied Volatility
Another critical mistake with which traders lose money is not understanding options’ implied volatility. It is a description of how much the market thinks the price of the stock can go in terms of percentage points, and it significantly works into the price of an option. It’s quite a significant mistake that most traders seem to make when they forget to monitor its impact, causing enormous losses, especially during major events such as earnings.
Example:
Let’s take an example of Apple on November 2nd, 2023—the day before it had made the earnings announcement. You have decided to buy an at-the-money straddle: you have bought both the call and the put, and the stock is trading at $177.57. The total cost for the straddle is $658.
The strategy had assumed that there would be this huge move in the price, either up or down, as a result of the earnings report. But the very next day, although Apple stock had moved pretty significant, options lost to the crushing after the event of implied volatility.
The stock closed at $176.50, and the options are expiring on a combined value of just $85, so you lost $573, even though the stock has moved. That’s because the volatility crush post-earnings.
Solution:
There’s a huge role that implied volatility plays in options pricing, particularly when and around earnings reports or other events. Just how that will feel impacting your options both before and after these events is important to understand.
If you expect a volatility crush, then you may want to sell options instead of buying them or else exercise strategies like Iron Butterflies that would decrease your exposure. The timing of, and dynamics of, the volatility cycles explain more to you about how you should make your decisions so that the risk of major losses gets reduced.
Conclusion: Overcoming Common Mistakes
More importantly, though, is the fact that more than 90% of options traders lose because they miss some of the key concepts driving options pricing and risk. The three major mistakes discussed—buying cheap options without understanding probability, underestimating the cost of timing and direction, and failure to understand implied volatility—are the root causes of most losses.
To flip that to a better profitable options trader, pay attention to the following:
- Know your odds of winning: Don’t fall for the trap of cheap options. Always think of the probability that the option will hit its strike price before it reaches expiry.
- Think about the timing and direction: Knowing the right direction is not enough. Try to gauge how far the stock may need to travel in what time frame.
- Implied volatility: how to understand how the volatility affects your options, especially when some high-profile events are like earnings announcements.
Options trading can be pretty profitable. However, to do it without committing all the common mistakes requires one to know what risks are involved. Knowledge of these common mistakes and proper application of strategies would really increase one’s chances of succeeding at options trading.