I’ve been trading options for almost 30 years now.
And during that time, I’ve spoken with hundreds of retail investors.
I get questions all the time. And I can tell you there are three options trading mistakes that retail investors need to avoid.
In today’s video, I explain how you can trade options like the pros on Wall Street.
(If you’d prefer to read a transcript, click here.)
Avoid These 3 Options Trading Mistakes By Ian King, Editor, Strategic Fortunes
Did you ever wonder what the three biggest option trading mistakes that retail investors make are?
Well, today I’m going to go over that in this short video.
Listen: I’ve spoken to hundreds of retail investors and hundreds of institutional investors. I’ve been trading options for, oh boy, almost 30 years now, and I can tell you the three simplest mistakes that retail investors make because I get these questions all the time.
What’s The Difference Between Options And Stocks?
But before that, I want to tell you exactly the difference between what an option is and what a stock is, and how you should think about it.
Now, if you’re buying a stock, you’re basically buying something where there’s nobody necessarily on the other side of the trade. Sometimes people can be short that stock, but for the most part there’s an outstanding issuance of stock for all companies.
You can buy it and hold in your brokerage account. And it’s not dynamic. It sits there and pays you dividends. It goes up, it goes down, perhaps.
But an option contract is different. And here’s why. For an option contract, when you buy one there’s somebody on the other side of that who’s selling you the risk. So, for instance, if you buy, let’s say an Apple call that expires two weeks or more with the strike price of $160, it gives you the right to purchase stock at $160 at expiration.
Now, the person who sold you that contract has the obligation to sell you that stock there, so they’re on the hook for selling you the stock. If the price goes higher, then the person who sold you that call option has to sell you the stock at a lower price than where it’s trading.
This is very fundamental to understand option trading. It’s similar to how you buy, let’s say, an insurance premium on your house or life insurance. There’s always somebody on the other side of that insurance contract who’s underwriting the risk.
And in the options market, when you’re just buying a call or buying a put, there are institutions and market makers and very sophisticated investors on the other side of those trades that are writing you that risk. And they understand not only the value in the price of that option better than the retail investor does, but also have a better grasp on where the underlying asset will be at expiration.
Holding Long Options
So, let me tell you the three biggest mistakes that retail option investors make.
No. 1 is buying and holding long options. Now, why is this a bad idea? Because every single day that you own an options contract, it’s losing value. And the reason for that is there’s time decay. You’re going to pay a premium for time, and every day a little bit of that premium is eroding.
Now, this premium actually accelerates as you get closer to expiration. So, with a month to go, you start to see the premiums on options really start to drain out, and that’s where option holders lose the majority of their value.
The key to this is just not sitting in long options for long periods of time. If you’re going to buy an option on the market, whether it’s a bet that the market’s going to go up, like a call option, or a bet the market’s going to go down, with a put option, you don’t want to hold it for longer than a week because you’re going to lose so much value in time decay that it’s going to be hard for you to actually make money trading it.
So, the key is not holding long options for extended periods of time.
Don’t Buy After A Stock Drops
No. 2 is a common mistake I see. It’s that investors buy call options after a stock drops.
And, you know, this might be enticing. You might see your favorite stock, like Microsoft, drop 5%. Then it bounces because the dip buyers come in, so you go in and you buy a call option.
Now, the reason why this is bad is because after a stock makes a big move, especially a downward move, there’s a higher amount of volatility that’s priced in the stock. So, the premium is going to be higher.
Think about it like if you were to buy insurance on your car after you just got in a bad accident or, you know, you got a speeding ticket. The insurance price is going to be higher. It’s the same thing for options.
If you’re buying a call option or a put option on a stock after it drops significantly, then you’re just going to be paying a higher premium. And even if it bounces, you have to overcome that premium to make money because as that stock bounces from the lows, the premium is going to drain out.
So, the No. 2 rule is don’t buy call options specifically after a stock drops. The better strategy, really, is to just sell puts or sell downward put spreads on it.
Don’t Buy Around Earning Events
No. 3 is another mistake I see a lot of retail investors make. And I’ve made this before in my career. It’s buying options around earning events.
The reason why you don’t want to do this is because the market makers and option traders understand that when a stock has earnings, there’s a possibility that there’s going to be a bigger move than normal. So, when you’re buying an option around an earnings event, you’re paying a higher premium than normal.
My favorite strategy is waiting until the news is out. And if it’s good, if the stock is up and looks like it has momentum, you’ll see those options become a lot cheaper, and then you can buy them and go for a sort of post-earnings move.
So, the key is to not buy options on earnings. Now, this isn’t a foolproof plan. And oftentimes people will go and buy call options ahead of, like, Tesla’s earnings or Amazon’s earnings, and it’ll work out really well.
But if you’re constantly buying rich options — those are ones that have high premiums — and not selling those options, you’ll lose money over time. And the point in case is that as this crazy statistic at the Chicago Board of Options Exchange points out, something like 90% of options wind up going out at zero at expiration.
So, it’s very difficult for you to make money on long options. This is why I created a system that helps you write premiums on the market like market makers do, like institutional investors do. I’m excited to launch it next week. Please sign up for our list today and join me on January 20.
If you like what we have to say in these videos, as always, please smash the like button. Sign up for our list, and I’ll see you on January 20. Thanks a lot.
Regards,
Editor, Strategic Fortunes
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