Don’t Make These Options-Trading Mistakes!

by | Oct 31, 2022

Have you ever opened an options chain and found yourself utterly confused as to what all the numbers mean?

I don’t blame you. I’m not gonna sugarcoat it … the options market can be very confusing to those just discovering it.

I was once in your shoes. I started as a penny stock trader over a decade ago, joining Tim Sykes’ Pennystocking Silver service, and then later his Trading Challenge.

While Sykes taught me everything I know about trading stocks, he doesn’t trade options. I had to learn that part on my own…

And let me tell you … If you’re coming from trading stocks — which is much more straightforward — options can seem overwhelming.

There are a variety of terms, concepts, metrics, and even ‘Greeks’ that you must understand to become a self-sufficient options trader.

In contrast, stock traders only have to worry about one thing — selling at a higher price than they bought for (or covering at a lower price than they shorted). 

This isn’t true for options traders. You can be directionally correct on an options trade and still lose money if you don’t avoid specific errors. 

That said, huge perks come with these extra considerations…

If you can wrap your mind around the factors determining how options are priced, you can potentially make orders of magnitude more money than a stock trader.

But the first step to options-trading success is avoiding the mistakes that often send traders back to their day jobs.

Keep reading and I’ll show you how…

Don’t Buy Contracts Too Far ‘Out-of-the-Money’

The beauty of options trading is that it gives you the ability to tailor-make your trades to your liking.

But with this ability comes danger. If you don’t know the potential perils of choosing a far out-of-the-money (OTM) strike price, you could get yourself into an account-ruining trade.

First, let’s talk about strike prices. This is the price the underlying stock needs to exceed by your expiration date for your contracts to pay out.

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If you buy a contract that’s far out of the money — and the underlying stock hits that number by your expiration date — you’ll make a bigger % gain than if you had bought at-the-money (ATM) contracts. 

This tantalizing possibility often lures newbie options traders into a trap. They look at the ‘max profit’ on the trade and think they’re gonna make it, but that’s a mistake.

If you buy ATM contacts, and you’re right about the direction, you’ll still make a much larger % gain than if you simply buy and sell shares.

On the other hand, if you’re holding OTM contracts and you’re wrong about the direction — even for a few hours — your position could lose more than half of its value. 

Bottom line: Don’t go for some pie-in-the-sky price target. Be realistic and pick a strike price that’s close to the money. 

NOTE: I usually trade strikes that are very close to the money, but slightly out of it, which gives me a solid risk/reward on the trade. 

Pay Attention to Volume, Open Interest, and Implied Volatility (IV)

Volume, open interest, and implied volatility (IV) … anyone who’s ever looked at an options chain has seen these metrics. 

However, many don’t understand them. I often see these terms confused with one another (or even misdefined) by newer traders. 

In short, these numbers measure liquidity and activity in the options market, but in different ways…

Volume

Volume is a running total of the number of contracts traded on a particular contract in a given trading day. 

Think of volume as a short-term liquidity indicator — it helps to see the flow of contracts on a near-term basis. For day traders of options (like me) volume is probably the most useful liquidity figure. It reveals the immediate action happening that day. 

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If a big news headline causes large-scale buys in a particular weekly contract, the volume on that contract will stick out like a sore thumb. 

Open Interest

Open interest measures the total number of contracts held in open positions on a particular strike price. 

In other words … If volume measures short-term liquidity, then open interest is its long-term counterpart. 

Where volume counts the contracts traded that day, open interest calculates all of the contracts sitting in traders’ accounts, including those that aren’t actively being traded. 

By closely monitoring these numbers, you can see which strike prices and expiration dates most traders are flocking to.

Implied Volatility

If a stock is really swingy, moving dozens of % over a few weeks, then the options contracts attached to the underlying stock will be more expensive than the average contract.

This is due to IV, a crucial factor for options traders to understand.

The higher the IV %, the more expensive the contracts are and the less you can potentially make on them.

This was particularly notable last week during big tech earnings. Tons of traders bought puts on Tesla Inc. (NASDAQ: TSLA) only to be surprised by how little their contracts moved the following day…

But had they paid attention to the IV, they might’ve avoided trading those puts altogether. 

If you’re not careful, IV can ruin the risk/reward on options trades, especially around earnings.

Final Thoughts

As you can see, failing to understand the metrics on an options chain can lead to trading disasters.

So, if you’re trading options and not grasping these concepts … it’s time to start studying.

Bottom line: You’ve gotta learn to love the formulas that determine options pricing if you plan on making millions in the market.

Meet Mark:

Mark Croock is a former accountant who after studying under Millionaire Trader Tim Sykes turned his small account into $3.19 Million in trading profits by applying Tim’s strategies to options trading.

He started Evolved Trader to pay it forward and help other traders learn how to leverage options

 

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