What Is Stock Option Trading & How to Trade Options?
As a newbie, stock option trading seems like a dream. You can make money when stocks go up, down, sideways and backwards. Not to mention the fact that you don’t need much money to get started to control a large chunk of shares. One options contract controls 100 shares of the stock and the amount of capital invested is much less than buying actual shares of the stock. While options are great, there’s some important things to know first before you get started. Watch our video on how to get started with stock option trading.
And with all the fancy options strategies out there, protecting yourself never seemed easier. But….
Here’s the catch.
You can also lose more than your entire investment faster than at the slots in Vegas. That’s why I can’t stress how important it is to proceed with caution; even seasoned traders can misjudge an opportunity and lose money.
What I’m going to do today is to cover the top 3 stock option trading mistakes I see beginners making – not to mention myself when I first started.
Stock Options Trading: Avoidable Mistake #1
Avoidable Mistake #1. Buying Out Of The Money (OTM) Call Options: They’re cheap; they’re appealing, but…they’re challenging to make money consistently on because the probability of success is so low. Stock option trading can go down the tubes with OTM options if you don’t know the correct strategy to trade them.
What to Do Instead?
If you’re stock option trading, why don’t you consider selling an OTM (out-the-money) call option on a stock that you already own? Your risk is next to nothing as you already own the stock.
What I like about this strategy – also known as a covered call strategy, is that it has the potential to make you money. That is of course if you’re willing to sell your stock if it goes up in price.
What I like about this strategy is that you get to dip your toes in the options trading world. You get the “feel” for how OTM option contract prices change as expiration approaches and the stock price fluctuates.
Your risk lies in having to sell the stock if the price rises and your call is exercised. So if you’re willing to assume this risk, selling otm spreads might be a good method for you. And it’s certainly a better probability than BUYING OTM naked calls.
Stock Options Trading – Avoidable Mistake #2
Avoidable Mistake #2. Trading Illiquid Options: Liquidity refers to the probability that the next trade gets executed at a price equal to the last one. It’s all about how quickly you can buy or sell something without causing a ripple effect. In this case, the ripple is a significant price movement, one in which we don’t want.
To prevent a ripple effect we need a liquid market. In other words, one with ready buyers and sellers, all the time.
When we compare the stock market and the options market, we see that stock markets are more liquid. And this is due to a straightforward reason: stock traders are trading just one stock — options traders have dozens of options contracts to choose.
Stock traders will flock to a stock that’s hot and running: one price, one share. But, options traders could have ten different expiration dates and a million of different strike prices to choose from.
Okay, I may have exaggerated a little bit but you get my point. Unfortunately, more choices, by definition, means the options market will probably not be as liquid as the stock market. Remember that stock option trading works in options market hours.
Illiquid Stock Option Trading Example
Take a large stock like IBM, for example. Liquidity is usually not a problem for stock or options traders. Where we see the problem creeping in is with the smaller stocks. Let’s say Planet Green Earth, my (imaginary) environmentally friendly energy company, might only have a stock that trades once a week. And, by appointment only – imagine that! So all things considered, if the stock is this illiquid, the options on Planet Green Earth will likely be even more inactive. What ends up happening is an artificially wide bid-ask spread on the option – this is what you don’t want.
Let’s look at it this way; if the bid-ask spread is $0.20 (bid=$1.80, ask=$2.00), and you buy the $2.00 contract, you paid a full 10% of the price paid to enter the position.
It doesn’t take a genius to figure out you just took a position with a 10% loss right out of the gate. Not a good idea. Moral of the story: Don’t burden yourself; never choose an illiquid option with a wide bid-ask spread.
Take our online trading courses in order to have an edge with stock option trading.
What to Do Instead?
I suggest you make sure the open interest is at least equal to 40 times the number of contracts you want to trade.
For your reference, open interest is the number of outstanding option contracts that have been bought or sold to open a position with a particular strike and expiration date.
Let’s do the math to trade a 10-lot. If it’s a 10-lot, your acceptable liquidity should be 10 (number of contracts) x 40 which equals an open interest of at least 400 contracts.
Avoidable Mistake #3
Avoidable Mistake #3. You Wait Too Long To Buy Back Short Options: I could go on and on about the many reasons why traders wait too long to buy back short options, but I don’t have enough time. You can see I listed a few reasons below, are you guilty of them?
- You’re cheap and don’t want to pay the commission.
- You hope the contract will expire worthlessly.
- You’re greedy and want to squeeze as much profit as you can out of the trade.
What Can I Do Instead?
Be smart and know when to buy back your short options. Better yet, always be ready and willing to repurchase them early.
Look at it like this; if your short option gets way OTM and you can buy it back profitably, do it. Take your risk off the table, don’t be cheap.
Here’s a good rule of thumb to determine when to buy back your short option: Buy it back if you can keep 80% or more of your initial gain from the sale of the option. Otherwise, I promise you one day a short option will come back to bite you because you waited too long.
Your Next Steps
I hope I made the stock option trading world a little bit simpler and easier to understand for you; they’re not as scary as you think. We will help you every step of the way if you’re ready to start your trading journey. With thousands of dollars of free courses and materials, we want to see you succeed.
As always, happy trading.