Most untrained option traders, and even seasoned stock traders and investors who have just moved onto option trading, make a series of mistakes, and that really shows a lack of understanding and a tendency to do things in a hasty way, a tendency to underestimate numerical values and data readings as being ‘too small and not much of an issue’.
The fact of the matter is that options pricing is a tricky process that can lead to nasty surprises if the trader overlooks minor details. A small change in an input variable can often result in a huge difference in the option’s profit potential.

Here’s the list of the most common mistakes and misconceptions about the options market that lead to trading mistakes and lack of attention:

1) Thinking that the options market is one of its own, and it’s not really directly related to the Futures market and the actual underlying stock market.

That is nonsense, all these 3 markets are directly related and impact each other, in fact the largest institutional traders, such as investment bankers always buy a Future or Option contract in advance, on the stock they plan to buy, this ensures they profit from the rally their own buying will cause, and offers them an overall cheaper entry price. The derivatives markets carry as much weight as the real thing, and are in fact inseparable. There are certainly some small ‘bucket shop’ option bet brokers out there, but their products are not real options and their market just follows the real thing without being physically connected to it, that is also the case with many small Forex brokers, real brokers however are directly connected with the real market, and you should do objective analysis based on the options pricing theory, and not treat it as a simple bet, because it’s not.

2) Getting the timing wrong, and using options with very short contract term, such as 2 months, in trades where they attempt to profit from stock price action over many days.

Options are wasting assets, remember that it is the extrinsic value part of an option’s premium that contains the time element, and that depreciates fast and exponentially within the last 30 days of the contract’s term, in fact the remaining 50% of this time element is lost within these last 30 days!

Always buy options with at least 3 months time left. That is for trades lasting many days, if used for short term trading you can use shorter expiration times, but always make sure you have at least 30-40 days left.

3) Buying way OTM options while the objective is to profit from quick stock price action.
There’s nothing wrong in buying OTM options, but these are suitable for large magnitude market moves, most traders get it wrong on the timing, and even though they could have made money trading a Futures contract or the stock itself, the non-linear profit curve of an OTM option is about making a lot of money on the ‘last’ dollar of market move, and this takes new traders by surprise. This means that in a stock price move from $35 to $45, you can often make nothing from $35 to $43 and you make a killing at $43, you make 90% of your profit on the last dollar of the move.

In this picture we see the profit curve of a Call option on a stock priced $36.87, and this is a relatively not so exponential profit curve case, as you can see, you can’t make any profit at all even if the stock rallies to $38.53 (4.5% up) that would have made serious money in a large size futures contracts trade, then at $38.74 (over 5% up) is just showing a $20 profit.

This option can make a fortune if the stock breaks out to $46 or higher, look at the profit projection, and all it cost to buy was $153 plus commission. But if the stock stays in a confined trading range then it is definitely not a good trade, for small price moves you are better off trading closer to the money or in the money options.

4) Ignoring the effect of volatility.
We know that volatility is a crucial factor in determining the extrinsic value part of an option’s premium, however many stock traders remained focused on stock direction only and completely ignore or underestimate volatility and its impact, you have to think both from the buyers and the sellers’ perspective, ‘How does the seller (option writer) view the trade?’

5) Not having a mentor / experienced trader to assess your trading
Training is important in every job, in every activity, just like when you learned to drive, and you had to take the instructor’s advice, in the same way, paying for a trading mentor is a good idea, he will identify early weaknesses in your trading and also stop you from taking unnecessary risks. Even if you are an experienced stock trader it’s still a good idea to seek professional mentoring on trading options.

Reading articles and books certainly helps, but then again you didn’t learn to drive through reading books, a mentor takes you though the false information, saves you a lot of trouble, and guides you straight to useful information that you can use in your own unique way, once the training is done your goal will be to beat your mentor using your own secret, and better, options strategy.

Author Bio: Option Software from Asio Investment Tools gives you the opportunity to practice on historical charts and test against actual market conditions-without risking a penny of your money! Intuitive, simple to use, Options Software http://www.optionseducation.org/

Category: Finances
Keywords: option strategies, options strategies, stock options trading, put call ratio, trade options, option