9 Ways to Destroy Your Account with Options
Options trading is fun.
Options trading is sexy.
And options trading can destroy your account if you don’t know what you’re doing.
Profitable options traders understand the principles of options pricing, order entry, and market mechanics.
If you fail to understand these 3 critical elements of options trading, you are not actually investing.
You are gambling!
So before you hit the buy button on your first options trade, carefully read through this list to make sure you are avoiding these deadly mistakes.
There’s a reason I know they’re deadly. I’ve made them all myself. Multiple times.
So please, be smarter than I was!
Mistake 1: Thinking the Guy on the Other Side of the Trade Is a Guy
There is no such thing as easy money in options trading.
Let me repeat: there is no such thing as easy money in options trading.
As you start exploring options, you’re going to be be tempted by options that are low in price.
Well, if the options are so cheap… why is somebody willing to sell them?
Remember, the guy on the other side of an options trade isn’t even a guy. Or a woman.
It’s a computerized algorithm developed by math and physics PhD’s that are way smarter than you or me.
Those algorithms generate millions of dollars a day by selling overpriced options to overeager traders.
If you think you see easy money, it's usually a trap.
Mistake 2: Trading Far Out of the Money Options
An option is far out of the money when its strike prices is far away from the current stock price.
Beginning options traders are often attracted to these options because they look cheap.
We’ll Tesla Motors (TSLA) as an example.
Let’s assume the stock is trading at $250.
An at-the-money call option expiring in 3 months is priced at $19 (or $1900).
But the $300 call is trading at just $4.
Many beginning traders will be more attracted to the $300 call simply because it has a lower nominal price.
However, far out of the money options require huge moves in short time frames to pay off.
So you’re paying less money out of pocket, but your trade is much less likely to make money.
Mistake 3: Trading Illiquid Options
Options on major stocks like Amazon.com (AMZN) and Apple (AAPL) tend to trade with fairly tight bid-ask spreads, and it’s fairly easy to trade in and out of them at reasonable prices.
However, you should be very careful with options on small and mid-cap stocks.
They tend to have very wide spreads and do not have much trading volume.
So odds are you’re going to have to overpay just to get into the trade, and get underpaid on the way out.
And in some rare cases — particularly with very far out-of-the-money options, you may have an awful lot of trouble getting trades completed at all.
Last year, I bought way, way out of the money put options on Ambarella (AMBA) puts and doubled my money.
However, there was no market for the options, and I couldn't get out at any price.
I went from making over 100% on the trade to losing 100%!
Mistake 4: Blindly Buying at the Bid and Selling at the Offer
As I said earlier, algorithms generate millions of dollars a day by selling overpriced options to overeager beginners.
How do they do this?
They buy low and sell high.
For example, right now I’m looking at April $17.50 calls on UnderArmour (UA).
The bid is $1.30 and the offer is $1.65.
That means the market maker will buy the option at $1.30 and sell it at $1.65.
That gives them a tremendous profit margin.
However, you don’t have to accept those prices.
Try bidding and offering in the middle.
For example, you could bid $1.48 (basically the midpoint) and still get filled.
That would save you 17 cents, or $17 a contract.
On a 10-contract trade, that’s $170!
Mistake 5: Not Double-Checking Your Orders
Before you hit send on your options order, double-check it.
When dealing with options, you’re often looking at dozens or even hundreds of small numbers on a single computer screen, and it’s easy to make mistakes.
Make sure you selected the right the expirations and strike prices.
This is especially important if you’re entering an order with multiple legs.
You may fool yourself into thinking you've found an especially attractive calendar or butterfly spread when in fact, you just got ripped off.
Mistake 6: Selling Options While Naked
Get your mind out the gutter!
Selling naked options entails shorting calls or puts without any kind of hedge.
This is what we call “picking up pennies in front of a steamroller.”
Let’s talk about naked shorting of call options.
This is a bearish trade because you will make money if the stock falls.
But if the stock rises substantially, you’ll get destroyed.
Let’s say we want to sell nVidia (NVDA) June $100 calls for $6.30.
If NVDA is below $100 at expiration in June, I’ll have made a pure profit of $6.30, or $630, per lot sold.
But if the stock was at $120 at expiration, the options would be worth $20 each, and I’d be out $13.70, or $1370, per lot.
These are the types of trades where 1 bad trade can wipe out your last 10 good trades, so just don’t do them.
Mistake 7: Ignoring the Calendar
Events like earnings reports, FDA decisions, product announcements, dividend payments, conference appearances, and economic data releases can have a tremendous impact on options prices
So before you place a trade, be aware of what’s on the calendar for the stock or ETF in question.
For example, if Alphabet (GOOGL) is about to report earnings, its options will tend to be very expensive in the days before the report.
Mistake 8: Not Understanding Options Pricing Basics
Most options beginners think a $0.01 option is cheap and a $10.00 one is expensive.
The reality is not that simple.
An option’s price is determined by a number of factors, and can’t be judged by price alone.
If you want to stay out of trouble, at the very, very least, you should understand how implied volatility and theta (or time decay) work.
Mistake 9: Not Getting an Options Education
As I said earlier, options trading can destroy your account if you don’t know what you’re doing.
So before you get started, take the time to learn the fundamentals of options pricing, order entry, and market mechanics.
They’re not nearly as complex as you may think.
And they’ll help you stop making mistakes that cost traders like you billions of dollars every year.