Trading Options is a great way to generate a consistent income.
However, if you want to be consistently profitable when trading Options, you need to avoid making deadly mistakes that can wipe out your trading account.
That’s because even if you have a profitable trading strategy but you make one or two deadly mistakes along the way, it may wipe out all your profits.
So here are the top five Option trading mistakes you must avoid at all costs.
Options Trading Mistake #1: Only Buying Options Instead of Selling Options
The first mistake is to only use premium-buying strategies and not premium-selling strategies.
I remember when I first started trading Options many years ago, I joined an Options newsletter that only focused on premium-buying strategies.
The newsletter only focused on Options strategies like debit spreads, calendar spreads, and diagonal spreads.
Needless to say, I wasn’t profitable.
That taught me a lesson and that is that if you want to be consistently profitable, you can’t only use premium-buying strategies.
In fact, only a small percentage of your Options portfolio should be on premium-buying strategies.
The majority should be focused on premium-selling strategies.
That’s because it’s very difficult to be profitable buying premium.
When you buy premium, Theta is working against you.
And more importantly, premium-buying strategies tend to be more directional by nature.
That means you need to be right in your direction in order to be profitable.
Whereas for premium-selling strategies, you can be wrong in your direction and still be profitable.
Also, premium-buying strategies tend to be low-probability trades.
For example, the highest probability of profit for a debit spread (Bull Call Spread or Bear Put Spread) is at most a 50% win rate.
And if you trade the calendar spread, the win rate is much lower.
Now, that is not to say that premium-buying strategies cannot be profitable.
They can, but it’s a steeper slope to climb compared to premium-selling strategies.
If you were to trade a debit spread with a 50% win rate, you can see in the table above that there is a 100% chance of 4 losing trades in a row.
That is quite a lot of losers in a row.
But there is also a 52% chance of 7 losing trades in a row, which is very possible of it happening.
The difficult part is being able to put on the next trade after having 7 losing trades in a row!
That is why it is very difficult psychologically to be profitable in trading premium-buying strategies.
On the other hand, if you trade a premium-selling strategy with a 70% win rate, there’s only a 100% chance of two losing trades in a row and only a 55% chance of 4 losing trades in a row.
After that, the probability of further losing streaks drops off significantly.
That is certainly much easier to trade compared to a 50% win rate strategy!
Options Trading Mistake #2: Focusing Only On Profits And Ignoring Risk
The next deadly mistake to avoid is focusing only on how much you can make and totally ignoring the risks involved.
Let’s use the simple strategy of a Short Put as an example.
The image above shows the order ticket of a Short Put on Amazon (Ticker: AMZN).
Many traders when putting on this trade would only look at how much they can potentially make.
And in this case, the premium they can receive for this Short Put is $250.
The next thing they look at is how much they need to put up for this trade.
And if you see the “Buying Power Effect”, aka Buying Power Reduction (BPR), it shows a negative $1,000.
That means you only need to put up $1,000 in capital to put on this trade.
So many traders look at this and say to themselves, “Since I have a $5,000 account, I can sell 5 Puts and make $1,000! That is an immediate 20% return on my capital in one trade! Easy money!”
The problem is that they ignored the “Max Loss” row, which shows a negative $9,750.
That means the potential loss is $9,750 per Short Put.
So if this trade sells 5 Put Options, then his potential maximum loss is $48,750.
Since he only has $5,000 in his trading account, his account can easily be wiped out if the market made a big enough move to the downside (which can happen).
And that is how many beginner traders get burned trading Options.
And this leads us to the next deadly mistake, and that is…
Options Trading Mistake #3: Trading Too Big
Let’s use the same Short Put trade example as above:
Here’s a question for you:
If you had a $50,000 trading account, how many Short Puts should you sell?
Here’s the answer:
Based on a 5% – 7% maximum allocation per trade, the most you can sell is two or three Short Puts.
That’s because your maximum allocation would be $2,500 to $3,500 at most per trade.
And since the BPR for this trade is $1,000 per trade, you only can trade two to three contracts.
Now, if you had a $20,000 trading account, how many Short Puts can you sell?
The answer is that you can sell only one Short Put based on a maximum allocation of 5% – 7% per trade.
And what if you only had a $10,000 or small trading account size?
Then the answer is that you can’t sell any contracts at all.
That’s because your maximum allocation per trade is only $500 to $700.
So a $1,000 BPR trade would exceed that.
So you would either need to either trade Credit Spreads, or find a lower-priced stock to trade a Short Put in.
Options Trading Mistake #4: Holding Till Expiration
The next trading mistake is one of the most common mistakes that beginners make, and that is to hold a trade till expiration.
This is something that many new traders can’t wrap their heads around because after all, if you want to get the maximum profit on a trade, you will need to hold it till expiration.
So why is holding till expiration a big mistake?
And if you don’t hold the trade till expiration, when do you exit?
Great questions, and I’m glad you asked (or rather, I asked)!
First of all, instead of holding your trade till expiration, you want to exit at around the 21 DTE (days to expiration) mark.
Numerous research and studies by the folks at TastyTrade have shown that you get better results exiting at 21 DTE.
When you hold your trades to expiration, your risk significantly increases, and your profit decreases.
The table above compares the result of the Bull Put Spread when holding till expiration versus exiting at 21 DTE.
As you can see, while the win rate slightly decreases, the return actually increases and the average loss decreases.
Secondly, when you exit your trades at 21 DTE, your loss is mostly contained to the BPR of the trade.
So in the Short Put trade example on AMZN shown earlier, if you exit at 21 DTE, there’s only a 1.1% chance that the loss will exceed the $1,000 BPR.
But if you held it to expiration, there’s more than double the chance of exceeding the $1,000 BPR.
And if you were to trade the Index ETFs like GLD, SPY, and XLE, by exiting at 21 DTE, you virtually will have no losses exceeding the BPR!
Finally, the long-term performance of exiting at 21 DTE is superior to holding till expiration.
The image above shows the cumulative performance of the Iron Condor comparing holding till expiration versus exiting at 21 DTE.
Clearly exiting at 21 DTE results in a better long-term performance.
Furthermore, by exiting at 21 DTE, there is a lower risk of getting assigned on any In-The-Money (ITM) Options.
Options Trading Mistake #5: Not Having An Exit Plan
Finally, the biggest Options trading mistake of all is not having an exit plan.
That means not having a thorough and concrete plan to exit your trades, including when to cut loss.
That’s because, by nature, no one likes to lose money, and so many people avoid planning the scenario where a loss happens.
And that usually results in huge losses like this:
So what is a thorough and concrete exit plan?
That is when you plan for ALL possible scenarios that can happen.
Let’s say, for example, you sell a Put Option on Google (Ticker: GOOGL) at the strike price of 100.
The next step is to plan for all the different scenarios that can possibly happen after you put on the trade.
So here are four scenarios that can happen.
Scenario 1: GOOGL stays above $100.
In this scenario, it is above your strike price.
So when do you exit?
Do you exit at 21 DTE?
Do you exit when a certain percentage of profit is reached?
Or do you exit when GOOGL goes to a certain price level?
Scenario 2: GOOGL goes below $100.
At this point, your Short Put has been breached.
What do you do?
Will you cut loss? If so, where and when?
Will you do nothing?
Or will you roll your Short Put? And if so, how will you roll it?
Scenario 3: After rolling, GOOGL goes above your strike price.
Let’s say you decided to roll.
And after rolling, GOOGL went up and your Short Put is now Out-of-The-Money (OTM).
What will you do at this point?
Will you do nothing?
Will you roll up your Short Put?
Or will you exit the trade? And if so, at which point will you exit?
Scenario 4: After rolling, GOOGL goes further down.
What if you rolled and GOOGL continues going down making your Short Put further deep ITM?
This is where you will likely see your losses grow.
So what will you do?
Will you continue holding in hopes that the market goes up?
Will you exit your trade for a loss?
Or will you roll again? And if so, how will you roll this time?
As you can see, there are many decisions to make after entering into a trade.
If you can plan all these out before you enter into a trade, you will never be caught by surprise regardless of what the market does.
This way, you will never reach a point where you let a single trade wipe your account out.
Remember, as long as you still have sufficient capital, you can always live to fight another day.
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