Option trading is a strategic but often complex area in the financial markets. However, if traders stay disciplined and follow a rule-based approach, much of this complexity can be managed effectively.
Let’s discuss three common errors—really more like “misses” than mistakes—in option trading. These are areas where small missteps can lead to significant losses, but once understood, the solutions become much clearer.
1. Selecting the Wrong Strike Price
A common pitfall among option traders is going after the lowest-cost option. While choosing a cheap product works for many purchases, options trading is an exception. For example, if a trader buys a call option with a strike price far above the current market price or a put option with a strike price far below it, profits will likely be minimal even if the price trend goes as predicted. This often results in frustration, as transaction costs can easily consume these small gains.
Miss: Far-out-of-the-money call and put options are less responsive to price movements in the underlying asset, which means that even if the market view is correct, profits may remain disappointing.
Solution: Limit your selection to options that are within 2-3 strikes from the current market price, whether for calls or puts, to improve profitability.
2. Unhedged Option Selling
Selling options can yield steady returns, but it carries the risk of unlimited loss. When options are sold on their own (without a corresponding hedge), they expose the trader to substantial risk with a capped profit—only the premium collected. For traders, taking on unprotected positions may be best avoided. Investors may use unhedged option selling as part of a broader strategy to enter or exit investment positions, which can work, but it’s different from short-term trading.
Miss: Relying on a stop-loss for risk management in naked option selling may not protect against major losses in the event of a sudden market gap up or down. Just one adverse trade could erase profits from multiple successful ones.
Solution: For each call sold, buy a call with a higher strike price and, similarly, buy a lower-strike put for each put sold. Although this will slightly reduce the premium received, it also reduces required margin and limits potential losses to the difference between the strikes.
3. Treating Options Like Lottery Tickets
Sometimes traders adopt a “lottery” mindset, hoping the underlying stock will move significantly within the expiry period, but preparing to lose the entire premium if it doesn’t. This approach often leads to holding unprofitable positions without a defined exit plan.
Miss: Carrying options without an exit plan can result in unnecessary losses and a dwindling premium due to time decay.
Solution: Approach options with the same rigor as stocks. Set both a profit target and a stop loss, including a time-based stop, since the option’s value will also erode over time.
