Five Mistakes to Avoid When Trading Options

(Especially since after reading this, you'll have no excuse for

making them)

We’re all creatures of habit — but some habits are worth breaking. Option traders of every level tend to make the same mistakes over and over again. And the sad part is, most of these mistakes could have been easily avoided.

In addition to all the other pitfalls mentioned in this site, here are five more common mistakes you need to avoid. After all, trading options isn’t easy. So why make it harder than it needs to be?

MISTAKE 1: Not having a defined exit plan

You’ve probably heard this one a million times before. When trading options, just as when you’re trading stocks, it’s critical to control your emotions. That doesn’t necessarily mean you need to have ice flowing through your veins, or that you need to swallow your every fear in a superhuman way.

It’s much simpler than that: Always have a plan to work, and always work your plan. And no matter what your emotions are telling you to do, don’t deviate from it.

How you can trade smarter

Planning your exit isn’t just about minimizing loss on the downside if things go wrong. You should have an exit plan, period – even when a trade is going your way. You need to choose your upside exit point and downside exit point in advance.

But it’s important to keep in mind, with options you need more than upside and downside price targets. You also need to plan the time frame for each exit.

Remember: Options are a decaying asset. And that rate of decay accelerates as your expiration date approaches. So if you’re long a call or put and the move you predicted doesn’t happen within the time period expected, get out and move on to the next trade.

Time decay doesn’t always have to hurt you, of course. When you sell options without owning them, you’re putting time decay to work for you. In other words, you’re successful if time decay erodes the option’s price, and you get to keep the premium received for the sale. But keep in mind this premium is your maximum profit if you’re short a call or put. The flipside is that you are exposed to potentially substantial risk if the trade goes awry.

The bottom line is: You must have a plan to get out of any trade no matter what kind of strategy you’re running, or whether it’s a winner or a loser. Don't wait around on profitable trades because you're greedy, or stay way too long in losers because you’re hoping the trade will move back in your favor.

What if you get out too early and leave some upside on the table?

This is the classic trader’s worry, and it’s often used as a rationale for not sticking with an original plan. Here’s the best counterargument we can think of: What if you profit more consistently, reduce your incidence of losses, and sleep better at night?

Trading with a plan helps you establish more successful patterns of trading and keeps your worries more in check. Sure, trading can be exciting, but it’s not about one-hit wonders. And it shouldn’t be about getting ulcers from worry, either. So make your plan in advance, and then stick to it like super glue.

MISTAKE 2: Trying to make up for past losses by “doubling up”

Traders always have their ironclad rules: “I’d never buy really out-of-the-money options,” or “I’d never sell in-the-money options.” But it’s funny how these absolutes seem obvious — until you find yourself in a trade that’s moved against you.

We’ve all been there. Facing a scenario where a trade does precisely the opposite of what you expect, you’re often tempted to break all kinds of personal rules and simply keep on trading the same option you started with. In such cases, traders are often thinking, “Wouldn’t it be nice if the entire market was wrong, not me?”

As a stock trader, you’ve probably heard a justification for “doubling up to catch up”: if you liked the stock at 80 when you first bought it, you’ve got to love it at 50. So it can be tempting to buy more shares and lower the net cost basis on the trade. Be wary, though: What can sometimes make sense for stocks oftentimes does not fly in the options world.

How you can trade smarter

“Doubling up” on an options strategy almost never works. Options are derivatives, which means their prices don’t move the same way or even have the same properties as the underlying stock.

Although doubling up can lower your per-contract cost basis for the entire position, it usually just compounds your risk. So when a trade goes south and you’re contemplating the previously unthinkable, just step back and ask yourself: “If I didn’t already have a position in place, is this a trade I would make?” If the answer is no, then don’t do it.

Close the trade, cut your losses, and find a different opportunity that makes sense now. Options offer great possibilities for leverage using relatively low capital, but they can blow up quickly if you keep digging yourself deeper. It’s a much wiser move to accept a loss now instead of setting yourself up for a bigger catastrophe later.

MISTAKE 3: Trading illiquid options

When you get a quote for any option in the marketplace, you’ll notice a difference between the bid price (how much someone is willing to pay for an option) and the ask price (how much someone is willing to sell an option for).

Oftentimes, the bid price and the ask price do not reflect what the option is really worth. The “real” value of the option will actually be somewhere near the middle of the bid and ask. And just how far the bid and ask prices deviate from the real value of the option depends on the option’s liquidity.

“Liquidity” in the market means there are active buyers and sellers at all times, with heavy competition to fill transactions. This activity drives the bid and ask prices of stocks and options closer together.

The market for stocks is generally more liquid than their related options markets. That’s because stock traders are all trading just one stock, whereas people trading options on a given stock have a plethora of contracts to choose from, with different strike prices and different expiration dates.

At-the-money and near-the-money options with near-term expiration are usually the most liquid. So the spread between the bid and ask prices should be narrower than other options traded on the same stock. As your strike price gets further away from the at-the-money strike and / or the expiration date gets further into the future, options will usually be less and less liquid. Consequently, the spread between the bid and ask prices will usually be wider.

Illiquidity in the options market becomes an even more serious issue when you’re dealing with illiquid stocks. After all, if the stock is inactive, the options will probably be even more inactive, and the bid-ask spread will be even wider.

Imagine you’re about to trade an illiquid option that has a bid price of $2.00 and an ask price of $2.25. That 25-cent difference might not seem like a lot of money to you. In fact, you might not even bend over to pick up a quarter if you saw one in the street. But for a $2.00 option position, 25 cents is a full 12.5% of the price!

Imagine sacrificing 12.5% of any other investment right off the bat. Not too appealing, is it?

How you can trade smarter

First of all, it makes sense to trade options on stocks with high liquidity in the market. A stock that trades fewer than 1,000,000 shares a day is usually considered illiquid. So options traded on that stock will most likely be illiquid too.

When you’re trading, you might want to start by looking at options with open interest of at least 50 times the number of contacts you want to trade. For example, if you’re trading 10 contracts, your minimum acceptable liquidity should be 10 x 50, or an open interest of at least 500 contracts.

Obviously, the greater the volume on an option contract, the closer the bid-ask spread is likely to be. Remember to do the math and make sure the width of the spread isn’t eating up too much of your initial investment. Because while the numbers may seem insignificant at first, in the long run they can really add up.

Instead of trading illiquid options on companies like Joe’s Tree Cutting Service, you might as well trade the stock instead. There are plenty of liquid stocks out there with opportunities to trade options on them.

MISTAKE 4: Waiting too long to buy back short strategies

We can boil this mistake down to one piece of advice: Always be ready and willing to buy back short strategies early. When a trade is going your way, it can be easy to rest on your laurels and assume it will continue to do so. But remember, this will not always be the case. A trade that’s working in your favor can just as easily turn south.

There are a million excuses traders give themselves for waiting too long to buy back options they’ve sold: “I’m betting the contract will expire worthless.” “I don’t want to pay the commission to get out of the position.” “I’m hoping to eke just a little more profit out of the trade”… the list goes on and on.

How you can trade smarter

If your short option gets way out-of-the-money and you can buy it back to take the risk off the table profitably, then do it. Don’t be cheap.

Here's a good rule-of-thumb: if you can keep 80% or more of your initial gain from the sale of an option, consider buying it back immediately. Otherwise, one of these days a short option will come back and bite you when you’ve waited too long to close your position.

For example, if you sold a short strategy for $1.00 and you can buy it back for 20 cents a week before expiration, you should jump on the opportunity. Very rarely will it be worth an extra week of risk just to hang onto a measly 20 cents.

This is also the case with higher-dollar trades, but the rule can be harder to stick to. If you sold a strategy for $5.00 and it would cost $1.00 to close, it can be even more tempting to stay in your position. But think about the risk / reward. Option trades can go south in a hurry. So by spending the 20% to close out trades and manage your risk, you can save yourself many painful slaps to the forehead.

MISTAKE 5: Legging into spread trades

“Legging in” is when you enter the different legs of a multi-leg trade one at a time. If you’re trading a long call spread, for example, you might be tempted to buy the long call first and then try to time the sale of the short call with an uptick in the stock price to squeeze another nickel or two out of the second leg.

However, oftentimes the market will downtick instead, and you won’t be able to pull off your spread at all. Now you’re stuck with a long call with no way to hedge your risk.

How you can trade smarter

Every trader has legged into spreads before — but don't learn your lesson the hard way. Always enter a spread as a single trade. It’s just foolish to take on extra market risk needlessly.

When you use Ally Invest’s spread trading screen, you can be sure all legs of your trade are sent to market simultaneously, and we won’t execute your spread unless we can achieve the net debit or credit you’re looking for. It’s simply a smarter way to execute your strategy and avoid any extra risk.

(Just keep in mind that multi-leg strategies are subject to additional risks and multiple commissions and may be subject to particular tax consequences. Please consult with your tax advisor prior to engaging in these strategies.)