Options are everything in life, and some traders embrace this concept.
Although trading options can help you make a lot of money, they can also turn out badly when not used correctly.
“If stocks move up, down, or sideways, traders may benefit. They can do so with a very minimal monetary input by employing options methods to limit losses, safeguard profits, and control significant pieces of shares. The drawback is that while trading options, you can potentially lose a lot of money in a matter of minutes,” connotes option trader and startup business loan provider Shane Perry of Max Funding.
It is thus essential to act with extreme caution.
Even the most experienced traders may make the wrong decision and lose money.
So, to help you avoid potentially expensive pitfalls, here are the five common option trading mistakes that you should avoid.
Mistake # 1: Trading Without Sufficient Knowledge
The first and most common options trading misstep is attempting to trade options without first gaining a thorough grasp of how things work.
Diving into anything that is perceived to be difficult to crack without first understanding the principles, features, and risks involved is something you should not do in options trading.
The market is littered with tales of novice traders joining the options market with high hopes only to leave empty-handed.
Mistake #2: Unplanned Trading
Many people who are new to trading fall into the trap of trading without a plan.
They undertake a stock investment without considering when to exit.
Many may believe that planning your trade is a complex undertaking; however, this is not the case.
An entry point, exit point, profit target price, the maximum loss you can accept, tactics you’ll use, and the highest alterations to your position should all be included in your trading plan.
Mistake #3: Not Making Use Of Probability
When considering whether or not to conduct a trade, consider the probability of your plan.
It would put what is mathematically likely to take into perspective, but it is also necessary to determine if your risk/reward ratio is reasonable.
It’s vital to remember that probabilities have no bias in any way.
Mistake # 4: Capital Misallocation
When trading options, generating profits of 100%, 200%, or even more in a brief span of time, is possible.
You may obtain these gains on very slight changes in the underlying.
However, depending on your purchasing options, you may lose all of your money in a single deal.
Given the threat of a complete loss on a transaction and the high potential of doubling, tripling, or even quadrupling your money, the amount you invest in options should be much smaller than your stocks.
This allows you to make the same earnings as a stock trader while putting much less capital at risk.
Mistake # 5: Poor Choice of Options
When trading options, there are several paths to take.
The advantage is the flexibility and freedom to match the time with the indicator(s) you’re employing; the disadvantage is that it may be scary and overwhelming for beginner options traders.
One consideration should always be your risk tolerance when purchasing options since specific options may yield better results than others.
Still, they also carry a higher potential to lose your entire investment.
Ready To Trade Options Smarter?
When done correctly, options trading may be an excellent method for portfolio diversification, risk mitigation, and profit generation.
Naturally, no transaction is risk-free, and if you’re not attentive, options may lead to significant losses.
You’ll have a greater chance of spotting and preventing these typical mistakes if you familiarize yourself with them.
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What is a call option?
A call option is a bullish strategy that allows a trader to profit from a trade on the upside.
The trader essentially bets that the price of a stock is going to go up by buying call options.
How does a call option work?
When you open the options chain, you will have many contracts to choose from, ITM, ATM, or OTM, which I’ll use as a quick example for now.
If you are betting on the price of a stock to go up, you might buy a contract with a strike price of a few dollars above the underlying securities’ current price, depending on your risk.
If the stock does indeed move up in price, you will begin to see gains on your contract.
You may then sell your contract and profit from your play when you are ready.
What is a put option?
A put option is a bearish strategy that allows a trader to profit off a trade on the downside.
Unlike calls, traders buying put options are betting the price of a security will drop.
How does a put option work?
I’ll use another OTM example for now and explain the other scenarios below.
You will have many options in the options chain to choose from.
Here you will be able to select a contract to buy based on the ‘strike’ price you’ve selected.
The strike price you’ve selected is where you believe the price of a security will go down to.
If a price of a stock is at $20 and you buy a contract for a strike price of $17, you’re betting that the price of the stock will fall in the future.
If the stock falls to $19 then $18, you will begin to see gains on your bet.
The closer the price of the underlying security gets to $17, the more gains you will see.
You can then close your position at any moment before the contract’s expiration date and take profits.
Both these examples are examples of an OTM contract which I’ll explain more below.
Here are other examples of how calls vs puts work.
What is ATM and ITM?
ATM stands for “at the money”.
At the money (ATM) is the current price a stock/security is trading at.
When your strike price is near the current share price this is considered to be “at the money” (ATM) for both calls and put options.
ITM stands for “in the money” and will be a little different for puts vs calls.
When a strike price is in the money for put options, it means the price is above the “at the money” (ATM) price.
Example: You’re betting the price of a stock will go down, so you buy a put options contract “ITM” for $11 while the stock is currently trading at $10 (ATM).
You contract has a higher probability to earn gains since the current share price (ATM) is already below your strike price (ITM).
The further the price of a stock goes down from your strike price, the more money you make.
When a strike price is in the money for call options, it means the price is below the ATM price.
Example: You’re betting the price of a stock will go higher so you buy a call option contact “ITM” at $9 while the stock is trading at $10 (ATM).
Your call option contract has a better probability of making money from the start since the current share price is already above your strike price.
If the price of that stock continues to surge, then you will continue to make gains.
“In the money” (ITM) contracts are a little more expensive to buy since your probability to make money is higher.
“At the money” (ATM) contracts which are closer to the “current” share price had a medium risk factor and are cheaper than ITM contracts.
So then what are OTM contracts?
OTM “out the money” explained
OTM, or “out the money” is the strike price above the ATM for calls, and the strike price below the ATM for puts.
Call option example: If you buy a call options contract OTM at $12 and the price of the stock is currently at $10 “at the money” (ATM), you are betting the price of a stock will rise above $10 per share.
Put option example: If you buy a put options contact “out the money” (OTM) at $8 and the price is currently at $10 “at the money” (ATM), you are betting the price of a stock will go below $10.
Remember, the closer a stock’s price gets to your strike price, the more gains you will reap.
So, the further out the money your strike price is, the higher the reward may be.
Should you buy ATM, ITM, or OTM?
Every trader will use the strategy that best tailors to their risk.
Out The Money (OTM) = High Risk / High Reward
At The Money (ATM) = Medium Risk / Medium Reward
In The Money (ITM) = Low Risk / Low Reward
Traders will need to study the performance of an underlying asset to get a feel and understanding of where the price may go.
Once you have determined whether you will be buying puts vs calls or vice versa, then you may begin to look at the contracts available.
Options contracts explained
Every 1 contract equates to 100 shares of a particular stock.
OTM contracts are usually less expensive.
With these contracts you can buy 100 shares of a stock for only cents.
ITM contracts are more expensive because they are the safest choice.
ATM contracts are in between ITM and OTM in pricing.
The options chain will allow you to choose when contracts based on short-term or long-term expiration dates.
You can go short or long on both a call and put options contract.
These expiration dates may vary from only a few days to weeks, to months, and even years.
Whether you should trade short-term or longer-term expiration options contracts is a strategy that will be highly based on your trading goals.
Where can you trade options?
The most popular platform to trade options is Webull.
Webull is where I personally began learning reading charts and familiarizing myself with the options chain and data.
Here traders will be able to purchase calls vs puts or vice versa.
Some traders use both strategies to make money during a bull and bear market.
Other platforms where you can trade options include:
If you’re already invested in stocks, you might already be using one of these platforms.
The difference between trading stocks and trading options is that you will need to open a margin account for options.
A cash account will not allow you to buy calls vs puts.
You can earn 5 free stocks from Webull when you sign up using my affiliate link.
If you choose not to keep these 5 stocks, you can sell them and fund your margin account to trade options.
Puts VS Calls: Why trade options?
Buying puts or buying calls allow traders to bulk up on stock and use leverage to make money in the stock market.
There are 4 different ways you can trade options.
All four essentially allow you to use leverage and make money whichever side of the play you want to begin trading options.
However, selling calls and selling puts from the get-go will require further in-depth explanation, which I will do in another article.
For today’s breakdown, I’ve explained buying both calls and puts.
There are a variety of things that attract investors to trading options.
Losses are limited to what you put in your contract
Quick accumulation of cash / shares
If you’re here today, it’s because you’ve probably seen people in your space talk about how much money they’ve made playing options.
And while options can yield a full-time income stream, new traders should also be aware of the risks.
Is trading options risky?
Trading options has its risks as bets aren’t 100% guaranteed to play in your favor.
However, there are a few things you can do to increase your chances at becoming profitable.
Familiarize yourself with technical analysis / chart patterns
Only buy what you can afford to lose
While traders can certainly trade based on market sentiment, it would be wise to gain some understanding of how prices move through technical analysis.
TA can help traders determine the trajectory of a stock’s price moves in the coming minutes, hours, days, and even weeks.
It’s best to armor yourself up and learn as much as you can to properly set yourself up for success.
If you’d like me to do a write-up on bullish and bearish patterns leave me a comment below.
When it comes to choosing between calls vs puts, it really comes down to adapting to the changes in the market to help you increase your income potential.
If you have any questions, be sure to leave a comment below.