Options trading offers retail investors (individual traders who buy and sell securities for their personal account) great opportunities to hedge risks and enhance returns. However, options are complex instruments that come with significant risks if used improperly. Retail investors have access to options trading through brokerage accounts, but often lack the advanced knowledge and skills of professional options traders. As individual investors new to options trading, retail traders should be aware of the common mistakes outlined below to avoid major losses. We have described the five biggest mistakes to avoid below.
Not Having a Trading Plan
Having a clear trading plan is essential for options success. Without a plan, retail traders are likely to make emotional decisions which rarely work out. Before entering any options trade, have a strategy in mind including:
- Clear entry and exit points
- Profit targets
- Maximum loss amounts you can withstand
- Overall timeframe of the trade
Stick to your trading plan once in the trade. Having a strategy mapped out ahead of time takes emotion out of trading.
Ignoring Risk Management Principles
Effective risk management is crucial. Only risk capital you can afford to lose when trading options. The limited upside with options versus uncapped downside requires disciplined risk management.Use stops, limits and position sizing wisely. Don’t overexpose yourself to trades where the risk/reward is heavily skewed against you. Managing trades and overall portfolio risk prevents options catastrophes.
Lacking Knowledge of Options Greeks
Options Greeks measure various risk sensitivities in options prices. Understanding Greek metrics like delta, theta, gamma, vega and rho is essential for managing an options trade.For example, theta indicates time decay. Holding options too close to expiration can lead to major losses if theta accelerates rapidly. Knowledge of Greeks helps retail traders anticipate risks.
Overtrading
Overtrading is common for retail investors new to options. Just because you can trade frequently with options, doesn’t mean you should. Overtrading leads to accumulating excessive fees and transaction costs.Be patient, wait for quality setups and stick to your trading plan instead of jumping in and out positions constantly. Refrain from impulsive trades that deviate from your strategy. A book such as The Complete Guide to Option Selling available here: jamescordier.com will help you with this.
Misunderstanding Implied Volatility
Implied volatility measures expected price swings of the underlying security. Higher IV leads to pricier options, while lower IV means cheaper options.Retail traders often make the mistake of selling options when IV is low after a period of consolidation. This can lead to losses if IV expands rapidly. Understand IV trends to better time entries and exits.
Avoiding Common Options Pitfalls
Options offer retail investors great ways to enhance trading returns and hedge risks. However, they come with their own complexities and risks. Follow sound trading plans, manage risk appropriately, know the Greeks, avoid overtrading, and understand IV trends. With education and practice, retail traders can avoid the above common options mistakes while benefiting from options’ advantages.
