As the song goes “We’re only human, born to make mistakes”. True or not, mistakes can cost an option trader lots of money. And if you’re trading your own account, you feel the effects even more.
Sometimes the mistakes can be small, like typing in a wrong digit on a limit order. Other times they can be large, like trading without a well thought out plan. Whether the mistake itself is large or small, they both have the potential to significantly impact your bottom line.
With that in mind, we’ll take a look at a few of these mistakes option traders make:
Failing to Plan the trade/trade the plan.
This is really a two sided situation, where you can fail on either one or both parts. The best plan in the world is of no use, if it isn’t followed. A simple plan followed is better than a sophisticated one that is not. I think you get the idea by now.
Planning the trade is done before the trade itself is put on. This is the time when you can think most rationally about it. There’s no money on the table, and you have nothing invested in it, either monetarily or psychologically.
Of course you’ve got to follow the plan once it’s devised. It’s easy to be distracted,or to second guess yourself in the heat of the moment. My advice: don’t do it. In the words of Kenny Rogers; “There’ll be time enough for countin’, when the dealings done.”
Not having a risk management plan.
You may be shocked, but hopefully you won’t. Are you ready for this? OK… here goes… not every trade you put on is going to be a winner. Though it may appear as common sense, it surprising how many people actually don’t have a risk management plan. They put on trades they “know” or “feel” are going to work. The amount of “feeling” they have in the trade working out determines how big a size they trade.
It can work. You could get lucky and your largest trades could be winners while your smaller trades end up the losers. But trade often and long enough, and chances are that it won’t work out that way.
There’s a saying “There are old traders and there are bold traders. But there are no old, bold traders” (source unknown). Something to keep in mind.
Having a risk management plan and not following it.
Yes it easy to throw caution to the wind. Specially when you are “sure” that this is the mother of all trades. As comedian Redd Foxx was fond of saying; “This is it Elizabeth. This is the big one”. Though your life may not be a Sanford and Son rerun, chances are good that it won’t be “the big one”. And if you’re not following your risk management plan, you better seriously hope it ain’t the big one, in a bad sort of way.
Pyramiding your profits.
This is something that sounds great in theory. And it can actually work in practice. But unfortunately there is no free lunch when it comes to trading. Those illustrations with a profit line zooming off the right hand side of a chart look absolutely lovely. But they’re just as likely to end up crashing down to the ground. If you’re the high rolling type, there’s probably nothing that can stop you, short of wiping out your account. Which you’re quite likely to do if you employ this tactic.
Putting on a position without understanding it’s risks.
Trading options is a lot more than just buying calls if you think a stock is going up, or buying puts if you think it’s going down. Having a complex position with multiple strikes and/or multiple months doesn’t necessarily put you in a better position either. For every option position that you create, there are trade-offs. It’s important to understand what those trade offs are in order to properly assess the risk you are undertaking.
An example is buying a calendar spread going into earnings. Sure it looks great on paper, but the reality is that you are taking on a huge volatility risk. Chances are good that the underlying stock will explode way past your break-even points. That’s why the front month options are so expensive. Chances are equally good that the stock goes nowhere, in which case the volatility will collapse and your spread will be worth peanuts.
Option trading can be very rewarding, but it’s no walk in the park. Yes you’ll make mistakes, maybe the ones I’ve written about and other ones too. But in order to be at the top of your game, you need to work on your craft, and practice, practice, practice.
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