Common Mistakes While Trading in Options

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a) Buying Options too close to the expiration date
This is perhaps linked to a larger issue of not completely understanding how the pricing of an option works. Many traders often make this mistake of treating derivatives like delivery.

It is important to remember that Time plays an important role in the price of an Option. The closer the option is to expiration, the price of the option continues to decrease, a phenomenon that is known as time decay.

Thus, when buying an option, it is important to check whether there is enough time till the expiration date for the stock to move in the expected direction. It is a good idea to buy more than twice the amount of time you think you’ll need for the trade to be profitable.

b) Ignoring Small Gains for Home Runs
The perception is that traders can only make money through big ‘home-runs’, wildly successful bets that yield huge rewards. In reality, these are extremely difficult to execute.

Many of the best traders earn small profits from consistent gains that together compound to make meaningful sums. Making high-probability but smaller gains might be a better idea at the start than going for bigger but lower-probability gains.

c) Trading in Illiquid Options
This is a bigger problem in India than it is in the western markets. The problem with illiquid options is the difference between a bid price and an ask price, ensuring that the trader begins his position with a disadvantage. The larger the difference, the bigger the loss he inherits when he buys the options At-the-money and near-the-money options with near-term expiration are usually the most liquid.

d) Focusing on Cheap ‘Out of the Money Options
Again, one of the reasons for this is a lack of understanding of the pricing mechanism of options. For an option, the trader not only needs to guess the direction of movement, but also the time period when this takes place. This is even more difficult to predict with ‘Out of the Money Options’

e) Ignoring Commissions/brokerage
Because of the high frequency and turnover involved in options trading, the brokerage charged by your broker turns out to be a significant amount in the scheme of things. The table below illustrates how much a seemingly innocuous brokerage charge of 0.30% can completely change the success of a trade.

A lot of our customers trade in Options and Derivatives. We have thus become familiar with some common mistakes that traders tend to make while investing in Options.

Here is a list of some of the most common:

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