InvestorQ : As an options trader, can you tell me about some of the common mistakes that I must avoid to be profitable?
rhea Babu made post

As an options trader, can you tell me about some of the common mistakes that I must avoid to be profitable?

2 years ago

As an options trader, it is common to feel overwhelmed. One of the benefits of trading options is that it gives you different ways to take advantage of what you believe may happen to the underlying security in terms of price movement in the stock or the index. But one of the trade-offs for the luxury of this variety is an increased risk for making mistakes. Even if you buy options and take limited risk of premium only, then also these risks can add up over a period of time. Let us look at some of the common mistakes that option traders make and why it is essential to avoid such mistakes. Note that this list is illustrative and not exactly exhaustive and you need to treat it as such.

Mistake of options strategy not matching your market view

An important component when beginning to trade options is the ability to develop an outlook for what you believe could happen. This applies to stocks and indices and you need to respect the view as the base case for your positions. Two of the common starting points for developing an outlook are using technical analysis and fundamental analysis, or a combination of both. Technical analysis revolves around interpreting market action (mainly volume and price) on a chart and looking for areas of support, resistance, and/or trends in order to identify potential buy/sell opportunities. Fundamental analysis includes reviewing a company's financial statements, performance data, and current business trends to formulate an outlook on the company's value. An outlook consists of a directional bias as well as a time frame within which you expect your view to work and generate money for you. The bottom line is that you make sure the strategy you opt for is designed to take advantage of the outlook you expect. Otherwise, having your trading bets at cross purposes with your view and based on external stimuli is not a great idea at all.

Mistake of choosing the contract with the wrong expiry

As with multiple strategies, you are faced with the issue of having multiple expiries to choose from. In India you have near month, mid month and far month contracts. Of course, once you develop an outlook, then selecting the proper expiration generally falls into place because there is also a time dimension to it. Your choice of expiry should be driven by these 3 questions that you must ask yourself. How long do I expect it will take for the trade to play out either partially or entirely? Do I want to hold the trade through a corporate action, stock split, bonus, dividends etc? Is there adequate liquidity to support my trade; both in the short term and the long term and on the buy side and the sell side?

Mistake of selecting the wrong position size

Trading positions, especially intraday trading positions are driven primarily by fear and / or greed. If you are greedy when making decisions, you could end up trading a position size that is too large for your barometer of affordability. This may occur when a trade goes against the outlook and then you're stuck with a crippling loss. On the other hand, you could be like some ultra conservative traders who trade extremely small and hence never make the cut of making big profits. Trading a small size is fine, but you miss out on big returns. There are some basic rules to follow to address this problem. Focus on rupee risk than on percentage risk; it is a lot simpler. Secondly, never take any decision without reference to your capital loss rules. Thirdly, make a distinction between risking your capital and risking your profit. That is way to take a sensible size of trade. When deciding on the trade size, be comfortable with the amount of capital you will lose if the trade doesn't go in your favour. Trade size should be large enough to make meaningful profits but small enough to get a good night’s sleep.

Mistake of ignoring the all important volatility in your calculations

Implied volatility is a measure of what the market expects volatility to be in the future for a given security. It is important to recognize if implied volatility is relatively high or low, because it helps determine the price of the option premium. Knowing if the premium is expensive or cheap is an important factor when deciding on what option strategy makes the most sense for your outlook. If the options are relatively cheap, it may be better to look at debit strategies, whereas if the options are relatively expensive, you may be better served looking for credit strategies.

Mistake of not understanding the importance of probability in day trading

Probability refers to likelihood. In fact all trading works on probability. You put your money in trades where the highest probability of profits and the lowest probability of loss. That is the basic rule. Hence understanding of probability is the key to your trading activity. Taking into account the probabilities for your strategy is an important factor when deciding to place a trade. Not only does it put into perspective what is statistically likely to happen, but it is essential to understanding if your risk/reward makes sense. It is important to note that probability has no directional bias. It is simply the statistical chance of price being at a particular level on the evaluation date, given the current factors.

The big mistake of not having a trading plan

One of the first steps in avoiding common trading mistakes is to have a sound trading plan. Trading plan is all about asking some basic questions. How much are you willing to risk per trade? How will you find opportunities in the market place? When will you enter the trade?

What is your exit strategy? Without a plan it becomes very difficult to improve as a trader and keep moving forward. Trading options involves a number of considerations both before and after the trade has been placed. Many of the mistakes mentioned can be accounted for before the trade is opened. The whole idea here is to avoid these common options trading mistakes in future trades.