Top 5 Mistakes New Option Traders Make & How To Avoid Them

Published on Thursday, August 9, 2018 by Chittorgarh.com Team | Modified on Wednesday, July 3, 2019

Options trading is an excellent way for savvy traders to make money by leveraging assets and managing risks. Options allow you to make a profit in all market situations-up, down or moving sideways. It is also a popular tool to hedge your investments. However, when you are new to options, it can look overwhelming. A new world!

As you learn the ropes of trading in options there's a high chance that you make mistakes resulting in loss of money. Some of these mistakes are even committed by experienced traders. In this article, we will discuss the top 5 common mistakes new option traders make and how to avoid them. Understanding these mistakes will help you avoid costly trades and make informed trade choices.

Top 5 Mistakes New Option Traders Make

Mistake #1: Trading without a plan

Most new traders start trading without a plan- On advice from a friend or after being inspired by reading an article in a financial magazine. Trading without a plan is like driving without a destination. The result: loss of time and money.

So start with a sound trading plan.

How to build an Options trading plan?

Your trading plan must include-

• Amount of money you are prepared to invest every month and every trade
• Type of options you want to invest in- equity, Nifty, Bank Nifty, Commodities etc.
• Expected returns from the trades
• Risk or loss, you are willing to take/absorb

Every trade you make must adhere to the plans. Resist the best of temptations to stay away from the plan by investing too much or risking too much. Good traders control their greed and fear and therefore are able to make rational trading decisions.

Start small when you invest. There's a lot to learn from reading on options. But there's a lot more you will learn from trading in options. So start small and then go big.

Mistake #2: Adopting a one-size-fits-all strategy

Predicting the market trend and picking the right strategy is the secret of options trading. A specific strategy may deliver you returns once but repeating it is a sure recipe for disasters.

How to predict the market outlook?

Experienced traders develop market outlook using fundamental and technical analysis of the stocks. They also factor in the micro and macroeconomic factors. So, for the long-term, learn to conduct the technical and fundamental analysis of the stocks. Read opinions and view from experts on various sites and magazines.

The next step is to pick the right strategy that matches with your market outlook.

How to pick the right options strategy?

Our Options Strategy Guide is one of the ways to understand various option strategies. We have a list of 25 strategies for different strategy level, market outlook, risk and reward potential etc. You can also compare strategies to find the right one for your outlook and trading preference.

Mistake #3: Buying out-of-the-money (OTM) call options

New traders get attracted to buying OTM call options. It is for two reasons- OTM call options are cheap and are easy to understand & trade. You buy at a lower price and sell at a higher price. Very few understand that Option pricing is not only dependent on the upward movement of the price of it's underlying but also the probability of reaching the strike price and the time decay.

Buying OTM Call options can result in losses even if your market outlook is bullish. You need to select the right strike price and must have sufficient time in your hand. So, don't just buy OTM Call options. Buy it only when it makes solid trading sense.

Mistake #4: Lack of an Exit Plan

Most new traders don't have an exit plan. This stems out from not having a target for profit or loss. How much money do you want to make from a trade? How much loss can you absorb? Do you want to sell the Options before expiry or want it to expire worthlessly? You need to know to build an exit plan.

An exit plan is essential for Options trading because it is time bound. Unlike stocks, you cannot keep it on hold for a long time and wait for recovery. Also, there is a variance in taxations on selling or expiring options.

'STT for selling options is 0.05% but, if you carry your trade till expiry and your options are in-the-money (ITM) and get exercised, then you will be charged 0.125%'.

Prepare an exit plan before you execute the trade. And stick to it. Have a realistic goal and sell when you have achieved it. Also, have a target for losses you can absorb. Once your trade hits the loss mark, exit from the trade.

Mistake #5:- Not Keeping an Eye on Time

Failure to factor-in time decay is one of the critical mistakes new option traders make. Also, many traders buy trades closer to expiry time seeing low prices of the Options. Time is one of the key differences between stocks and options. Time decay plays an important role in the pricing of the Options. Each passing day reduces the value of your Options.

Always factor-in time while considering the trade. Keep time in your hand and make trades in the starting weeks of the Options calendar.

Common wisdom says- we learn from our mistakes. Same goes with the Options trading. But we must also learn from the mistakes committed by others. Avoid these mistakes new options traders make and save yourself from losses.