Options trading offers many options to traders, investors as well as hedgers. There are some common mistakes that option traders commit. Five of the most common mistakes are, taking too much leverage, not having a pre-defined stop loss and target, acting on tips on social media, adhering to buying options, and taking unhedged trades.
Options are derivatives tools that can be used by traders, investors, as well as arbitrators. Options are essentially a contract between the buyer and the seller to exchange the underlying security on a particular date and at a pre-defined price. Options are very effective when it comes to hedging your portfolio or speculating on a particular stock or index.
The leveraged nature of options makes them extremely risky and extremely profitable simultaneously if done right. Options trading requires a good amount of skills and experience. Therefore you shouldn’t start trading in options if you are a new entrant in the stock markets.
Options are already leveraged products, on top of which many brokers provide an additional 5 to 10X leverage. This eventually means you are taking an exposure of 1000 with a capital of 100. This is good if you are capable to generate consistent profits. Even a 10% gain on the capital of 1000 is equal to making 100% on your initial capital.
Although this sounds extremely tempting, remember leverage is a double-edged sword. If your position goes against you and you lose 10% in a trade, your whole capital will be wiped off. Hence, it is best to take calculated bets and utilize only the margin that you truly need and can manage.
Options trading is not a linear process. Various strategies require you to hold your trade for more than a week or month. In this case, you should have a predefined stop-loss and a target for all your positions. Even if there are no existing rules to place your stop loss and target. Ideally, you should not risk more than 2-3% of your entire capital in one trade. At the same time, you should also ensure you don’t utilize more than 15-20% of your capital in one trade. These are some of the very basic principles which you should refer to when figuring out a stop loss for your trade. On the other hand, your ideal target should be at least twice that of your stop loss. In terms of ratio, your Risk to Reward should be a minimum of 1:2 to become a profitable trader.
Options trading consist of two parts. One is Options buying and the other is Options selling. Options strategies are usually formulated with a combination of both buying and selling. This not only reduces the overall risk but also increases your winning probability. Trading naked options have it's now benefits such as higher rewards, but on the flip side, there is much more downside associated with it.
Naked option selling exposes the options seller to unlimited risks whereas the maximum profit is capped. Similarly, unhedged positions require more margin money or upfront capital as compared to hedged strategies. This is because SEBI provides more margin benefit for hedged positions as the maximum loss is capped.
Every day, there are many new entrants in the stock markets looking for making a quick buck on the side. These investors and traders look for quick tips to make some money but fall prey to the so-called market gurus from social media. Many individuals exploit the interest of newbies by providing trading tips and calls to make money for themselves.
These tips might have a vested interest or hidden agenda which you don’t know. Hence, it is important to not fall for these tips and instead learn and analyze the markets on your own. There is a plethora of good-quality content available on the internet that you can access for free. You can use these to your advantage and apply them to do your own analysis which will help you to stay ahead of the masses.
Small retail traders are often drawn towards Options buying because of the minimum capital requirement. You can buy an option for as low as Rs 1,000 but you need a minimum of Rs 80,000-90,000 to sell an options contract. Many small traders don’t have sufficient capital to sell options hence they adhere to buying options. Buying options may look like a lucrative option but there is a reason why they are so easily accessible.
The probability of making money by buying options is extremely slim. The chances of winning by options buying are merely 33% whereas the chances of winning by selling options are 67%. Due to this reason, most options buyers lose the majority of the time. The limited risk and unlimited reward proposition seem to be intriguing, but the actual reality is different. 95% of the OTM (Out of The Money) options expire worthlessly. This means if you had bought an OTM option and held on to it till expiry, there is a 95% chance that you will lose money.
These were the 5 most common mistakes which options traders make. If you are able to successfully avoid these mistakes, you will automatically increase your chances of being a profitable options trader.