7 big mistakes when trading cheap options

Many traders make the mistake of buying cheap options without fully understanding the risks. The cheap option is the absolute low-cost option. However, the true value is often overlooked.

These traders confuse cheap options with cheap options. Low-priced options refer to options that are traded at a low price relative to their fundamentals. It is undervalued, not just cheap. Investing in cheap options is different from investing in cheap stocks. The former tend to take greater risks.

Since the volatility of options is much higher than that of stocks, following strict rules is an important part of risk management.

As Gordon Gekko famously said, “Greed, because there is no better word, is good.” Greed can be a huge driver of profit. However, when it comes to cheap options, greed can even induce experienced traders to take unwise risks. After all, who doesn’t like to make huge profits with the least investment?

The combination of out-of-the-money options with a short expiration time looks like a good investment. The initial cost is usually low, and if this option is implemented, the potential profit is greater. However, it is worthwhile to understand these seven common mistakes before trading cheap options.

1. Don’t understand volatility

Option traders use implied volatility to measure whether an option is expensive or cheap. Use data points to show future volatility (possible trading range).

High implied volatility usually means a bearish market. When fear occurs in the market, the perceived risk sometimes pushes up prices. This has to do with expensive options. Low implied volatility usually means a bullish market.

Historical volatility can be plotted on a chart, and it should be carefully studied to compare with current implied volatility.

READ ALSO:   4 ways to trade options

2. Ignore odds and probabilities

Han Solo said, “Never tell me the odds,” but smugglers don’t know much about options trading. The market does not always perform according to the trend shown in the history of the underlying stock. Some traders believe that buying cheap options can help mitigate losses by using capital. However, traders who do not follow the rules of odds and probability may overestimate this protection. Such an approach may eventually cause heavy losses. Odds simply describe the likelihood of an event happening or not happening.

Investors should remember that cheap options usually have a reason. The option is priced based on the statistical expectations of the underlying stock’s potential. The value of an out-of-the-money option contract depends largely on its expiry date.

3. Choose the wrong time frame

Options with a longer time range will cost more than options with a shorter time range. After all, the stock has more time to move in the expected direction. Longer-term options are also less susceptible to time decay. Unfortunately, the temptation of cheap near-month contracts is irresistible. At the same time, if the stock changes do not meet the expectations of the purchased options, it may be catastrophic. For some option traders, it is also psychologically difficult to deal with stock movements in a longer time frame. As stocks go through a series of typical ups and downs, the value of options will change dramatically.

4. Ignore sentiment analysis

Observing short interest, analyst ratings and put option activity is a clear step in the right direction. The great speculator Jesse Livermore pointed out that “The stock market is never obvious. Its purpose is to fool most people most of the time.” This may seem frustrating, but it does make for trading. The author opens up some possibilities. When emotions become too strong on one side or the other, huge profits can be made by short betting. Inverse indicators, such as the put/call ratio, can help traders gain an advantage.

READ ALSO:   Profit from any price changes of long straddle options

5. Rely on guessing

Regardless of whether the stock is up or down, or is trading sideways, it is a big mistake to ignore the fundamentals and technical analysis when buying options. Easy profits are usually calculated by the market. Therefore, it is necessary to use technical indicators to analyze the underlying stocks to improve timing.

In fact, market timing in the options market has better arguments than stock markets. According to the efficient market hypothesis, it is impossible to make accurate predictions about the direction of stocks. However, the Black Scholes option pricing model provides very different prices for similar options based on current volatility. If the efficient market assumption is correct, then option buyers with longer time horizons should be able to improve performance by waiting for lower volatility.

6. Ignore intrinsic value and extrinsic value

Extrinsic value, rather than intrinsic value, is usually the main determinant of the cost of a cheap option contract. As the expiration date of the option approaches, the extrinsic value will gradually decrease and eventually reach zero. Most options expire worthless. The best way to avoid this terrible fate is to buy options with intrinsic value. Such options are rarely cheap.

READ ALSO:   tape

7. No Stop Loss Order

Many cheap option traders give up the protection provided by simple stop-loss orders. They prefer to hold the option until it is realized, or give up when it reaches zero. Due to the high volatility of options, the risk of early stop loss is definitely greater. Those with strict discipline may wish to switch to mental stop or automatic notification. If the notification is just a flash in the pan due to the occasional lack of liquidity in the options market, it can always be ignored.

Stop loss orders for options, whether psychological or actual, must allow greater losses than stocks to avoid washout. Growth investor William J. O’Neil recommends limiting losses to 20% or 25% when trading options. This far exceeds the 10% limit used by many stock traders for stop-loss orders.

Bottom line

When trading cheap options, both novice and experienced option traders can make costly mistakes. Don’t assume that cheap options have the same value as undervalued or undervalued options. Among all options, the 100% risk of loss is usually the highest for cheap options. The cheaper the option, the less likely it is to expire.

Before taking risks with cheap options, please do your research first and avoid paying excessive fees for option transactions. The fees are much lower than before, so transaction costs should not be a problem. Take a look at InvestingClue’s list of the best options brokers to make sure you don’t pay too much for options trading.


Share your love