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Five Mistakes to Avoid When Trading Options

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Knowledge Knowledge Section. Recent Articles. What Is Options Trading? The basics of options To trade options, you first have to know what they are. What are the benefits of options trading? They include the following: Options give you leverage in your investing. An options contract can give an investor cheaper exposure to a stock than buying shares outright, magnifying both profits and losses if the stock price moves. Options can also reduce risk in your overall portfolio.

For instance, you can use an option strategy that combines buying a put option to sell stock at a specified price with ownership of the shares themselves. That trade, known as a protective put, gives you the upside if the stock price rises but protects you from a portion of the losses if the stock price falls. Options can offer a source of income. By selling options rather than buying them, you're the one to receive the payment for the option.

Even if the option goes unexercised, you get to keep that payment as compensation for having assumed the obligation for the contract. What are the risks of options trading?

Options Trading Strategies | TD Ameritrade

Picking the best options broker If you want to trade options, then finding a top stock broker is crucial. Here's what to look for: Low commissions : Virtually all online brokers have eliminated commissions on stock trades. But the same typically isn't true with options -- a few brokers offer free options trades, but the majority charge a modest per-contract position for options. Good research : Special tools for evaluating options can be very useful, but not all brokerage companies offer them.

Good trading platform : Any no-frills trading platform can be fine for buy-and-hold stock investors, but a feature-packed platform can be a major advantage for an options trader. Great customer support : Options traders are more likely to have to talk to customer service agents in order to get their trades done the way they want, especially for more complicated strategies. Nothing's more frustrating than having a broker's customer service representatives not really understand what you're trying to do with your options trading.

Take a closer look at options Of course, options trading is a far more complex subject than we can explain in a 1,word article, so it's important to spend some time learning about various options strategies and the risks involved before you get started. About the Author. Blue Twitter Icon Share this website with Twitter. Email Icon Share this website with email. Back to The Motley Fool. Rick's calls would expire unexercised, enabling him to retain the full amount of his premium.

If you are a call or a put buyer, choosing the wrong strike price may result in the loss of the full premium paid. This risk increases when the strike price is set further out of the money. In the case of a call writer, the wrong strike price for the covered call may result in the underlying stock being called away.

MISTAKE 1: Not having a defined exit plan

Some investors prefer to write slightly OTM calls. That gives them a higher return if the stock is called away, even though it means sacrificing some premium income. For a put writer , the wrong strike price would result in the underlying stock being assigned at prices well above the current market price.

That may occur if the stock plunges abruptly, or if there is a sudden market sell-off , sending most share prices sharply lower. The strike price is a vital component of making a profitable options play. There are many things to consider as you calculate this price level. Implied volatility is the level of volatility embedded in the option price. Generally speaking, the bigger the stock gyrations, the higher the level of implied volatility. Most stocks have different levels of implied volatility for different strike prices.

That can be seen in Tables 1 and 3. Experienced options traders use this volatility skew as a key input in their option trading decisions. New options investors should consider adhering to some basic principles. They should refrain from writing covered ITM or ATM calls on stocks with moderately high implied volatility and strong upward momentum.

Unfortunately, the odds of such stocks being called away may be quite high. New options traders should also stay away from buying OTM puts or calls on stocks with very low implied volatility. Options trading necessitates a much more hands-on approach than typical buy-and-hold investing. Have a backup plan ready for your option trades, in case there is a sudden swing in sentiment for a specific stock or in the broad market.

Time decay can rapidly erode the value of your long option positions. Consider cutting your losses and conserving investment capital if things are not going your way. You should have a game plan for different scenarios if you intend to trade options actively. For example, if you regularly write covered calls, what are the likely payoffs if the stocks are called away, versus not called?

Suppose that you are very bullish on a stock. Would it be more profitable to buy short-dated options at a lower strike price, or longer-dated options at a higher strike price? Picking the strike price is a key decision for an options investor or trader since it has a very significant impact on the profitability of an option position. Doing your homework to select the optimum strike price is a necessary step to improve your chances of success in options trading.

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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Strike Price Considerations. Risk Tolerance. Risk-Reward Payoff. Strike Price Selection Examples. Case 1: Buying a Call. Case 2: Buying a Put. Case 3: Writing a Covered Call. Picking the Wrong Strike Price. Strike Price Points to Consider. The Bottom Line.