Option Traders: Are You Avoiding the Traps?

Six mistakes to avoid when trading options

I promote option trading.  I know that conservative option strategies can help millions of investors earn more money, more consistently, and with less risk, when compared with buying and holding a diversified stock portfolio.

I know that options are risk-reducing investment tools.  But only when used intelligently.  One purpose of the Options for Rookies blog is to encourage you to learn how options work – enabling you to discover whether options are suitable for you, your investment goals, and most importantly, for your personality.

Today it's necessary to discuss the negatives associated with option trading.  When used improperly by people who have not bothered to understand the risks and rewards that come with with using options, option trading can quickly decimate your investment account.

Far too many individual investors begin trading options before learning how to use them properly.  It's not that different from learning to drive a car.  It looks easy.  It seems that you don't need instructions.  If given an opportunity many would climb into a car believing they can learn as they go.  Some do manage to learn via that path.  But it's foolish.  Not only is that driver endangering him/herself and the car, but the lives and property of others are jeopardized by that uneducated, novice driver.

If you jump into option trading, you endanger yourself and your bankroll.  The good news is that the lives of others aren't being jeopardized.  But that's not good enough.  If you believe that buying and selling options is a simple game and that you can learn all you need to know as you gain experience – then you are misinformed.

I frequently write about using options to improve your financial life.  But today it's time for a warning – time to inform everyone (who does not already know) that

  • The options game is not 'free money' 

  • There is much to learn

  • Risk can be deceptively large

In short, I hope that helping you understand what not to do, you will pay serious attention to learning how to use options before using real money.

Option trading is not a game.   It's a serious business that requires an understanding of the rules of the game.  BEFORE you begin trading.

***

Here's a partial list of things to avoid:


  • Don't use options for gambling.  Don't buy inexpensive, low-delta options looking for a big score (those big wins are rare)

  • Don't ignore risk when mesmerized by potential profits (It's easy to lose 100% of your investment when buying options.  Selling naked options can quickly bankrupt your account)
  • Don't depend on the market doing what you predict it will do (few can consistently predict market direction)
  • Don't blindly follow trade suggestions (their trades are most likely unsuitable for you)
  • Don't pay thousands of dollars for educational seminars (better information is available at little or no cost)
  • Don't depend on hope (hope is not a strategy)


With the obvious bias of the author, I recommend The Rookie's Guide to Options as the best options primer available.  The amazon.com reviews are typical of e-mails I receive from satisfied readers.  A sampler version is available at no cost.

568

10 Responses to Option Traders: Are You Avoiding the Traps?

  1. Steve 01/05/2010 at 8:30 AM #

    Just wanted to let you know, I enjoyed the book. I have read a number of options books, an yours was concise and very thorough even for a trader with some experience.
    Would enjoy seeing an intermediate or beyond text from you, as the few that I have read have not been beneficial.

  2. Mark Wolfinger 01/05/2010 at 8:35 AM #

    Thanks Steve,
    That’s a big project. Do have any specific topics you would want to see included?

  3. not steve 01/05/2010 at 11:35 AM #

    I’d like to see
    1. lots more detail on techniques for adjustments of positions since that’s where the money is ultimately made or lost (you’re doing a great job of this in the blog and it’d be useful to have it all in one place, and in even more detail),
    2. techniques for creating a smoother income stream in different market conditions by setting up a mixed portfolio of various sorts of option positions,
    3. analyzing worst case scenarios and how to avoid them,
    4. greater use of pay off diagrams in the discussions since it’s a quick way to present a lot of related information.
    For the blog, I’d like to see your thoughts on some of the interesting backtested mechanical trading ideas that Jim Bittman has presented in CBOE videos. They seem almost too good and I wonder if backtesting data from different time periods would subtantially change the outcomes. But possibly that is beyond the scope of this blog.

  4. KhaiPA 01/05/2010 at 12:16 PM #

    If you jump into option trading, you endanger yourself and your bankroll. The good news is that the lives of others aren’t being jeopardized.
    Not the lives of others, but you could put your brokerage firm at risk, for example, by failing to meet a margin call when your naked options have gone awry.

  5. Steve 01/05/2010 at 12:22 PM #

    You are right that it would be a big project.
    What is hard about even thinking about writing an options book is that there are many different strategies that benefit from different things such as trading volatility, directional, and directionless approaches.
    Many are similar in their makeup, and yet they are different including their management approaches.
    To me an advance book that tries to address all of these topics will leave out a lot of details with regard to the “big picture” of managing an options portfolio.
    I think an options book that would focus on 1 or 2 strategies and go through a few trades with different scenarios over a few months, and how one could manage the risk while using P+L and the Greeks for a multi- expiration options portfolio would be nice.
    You have done this well in your Rookies’s book and on your blog. And I must admit to recently going over your twitter archives and piecing together different trades that you posted and the reasoning behind those trades which was very enlightening. You have a lot of good information in those tweets.

  6. Mark Wolfinger 01/05/2010 at 12:29 PM #

    Hi Not,
    Thank you for the ideas. This is very helpful.
    I have not seen those videos. Don’t know if I can schedule time to do that – I am soooo busy.
    I’ve never been a ‘back-testing’ fan because there so many variables that go into the pricing of options – and hence, into the profitability of a specific trading idea.
    As you are aware, a sudden volatility surge or crush can result in a quick, unexpected gain or loss. And that’s something that back-testing could never predict.
    Once again, many thanks.

  7. Mark Wolfinger 01/05/2010 at 12:33 PM #

    If one customer’s failure to meet a margin call jeopardizes the firm, then something is very wrong with that firm, and much stricter limits should have been placed on that customer’s account.
    But I do see your point. Others can be hurt (the trader’s family, for example) when someone takes out-sized risk.
    Unless you are a huge bank. For them, there is no risk that’s too large. And there is always a bailout.

  8. Rob 01/05/2010 at 12:40 PM #

    Hi Mark,
    I wanted to chime in here and mention that like Steve, I’ve tried to pieced a few trades together via your tweets. You’ve mentioned that you’re not comfortable posting detailed trade info for fear of people taking it as a recommendation. That said, I know that I would follow along on paper and learn something even if I wasn’t comfortable with the trade. I learned a LOT from watching D. Sheridan’s webinars because there’s plenty of detail regarding adjustments of calendars and d. diags. I think you and Dan have different styles, though I find them complimentary to be sure.
    There seems to be a common theme in the blog comments where readers are asking for more specific examples, and I really think the intent is to learn rather than get a trade recommendation.
    Keep up the great work! Regards, Rob

  9. Mark Wolfinger 01/05/2010 at 12:51 PM #

    Steve,
    Thanks.
    I’m working on a book about the kite spread. The audience for that is going to be much smaller than an ‘iron condor’ book – but it will contain a bunch of examples.
    Your idea of the all-encompassing book is sound and such a product may be needed. One problem is deciding what to include.
    Another problem is that trading is not physics. There are no rules that must be followed or physical laws that always provide reproducible results.
    When you deal with probabilities, the ‘average’ result may be defined, but the chances of achieving that exact result are small. That means there are many ways to approach the given trade – and one author’s opinions may not be sufficient. The thought of getting 10 people to discuss the identical topic – each from his own perspective – may be intriguing. But the book would probably be too repetitive. Still, it’s an idea…

  10. Mark Wolfinger 01/05/2010 at 12:59 PM #

    I agree: for most the intent is to learn.
    I’m going to post this as a special post. In a few minutes