Options, like futures, are contracts traded in the derivatives market, and they derive their value from underlying assets like stocks or indices. Now, venturing into the derivatives market to trade options may seem like a very lucrative proposition. Option values are very volatile, and if you play the right cards—with diligence—you can make fortune trading options. But the volatile nature also makes options trading a complex and risky endeavour. In fact, a majority of retail investors and traders in India lose money trading options.
So, if you plan on getting into options trading, it’s important that you are aware of potential pitfalls and avoid making mistakes that could lead to significant losses. So, this blog will outline five things you should avoid doing as an options trader.
- Don’t Rush to Trade with a Lack of Understanding
If you plan on trading options, it’s essential to understand the underlying asset fully, the options themselves, and the potential risks and rewards involved. Failing to understand even one of the three elements can lead to costly mistakes and a lack of success in your trades. It’s essential to take the time to thoroughly research the underlying asset and comprehend its financial health. This involves understanding the mechanics of options trading, which includes the expiration date, strike price, and the potential for time decay. Pay special attention to the last one—time decay—as time decay can erode your profits at an accelerating pace. So don’t rush to trade options as soon as you download your online stock trading app.
- Don’t Trade Without a Concrete Trading and Risk Management Strategy
Acquainting yourself with the mechanics of options trading is only the first step. Next, you need to construct an effective trading strategy using technical analysis. You should know when to take a trade and when to get out of a trade. That said, even if you have a robust trading strategy, there are no guarantees that trade will play out as expected. That makes risk management a crucial aspect of options trading, and having a risk management plan is equally as important as having a trading plan. You can manage your risks by setting stop-loss orders, using hedging strategies, or diversifying your portfolio. At the same time, it is also vital that you understand your own risk tolerance and make sure that your trades align with your overall investment goals and risk profile.
- Avoid Losing Track of the Markets
As an options trader, you will have to constantly monitor market conditions, including economic indicators, political developments, and news events that can impact the underlying asset. For example, you wouldn’t want to hold a trade while the RBI is announcing its interest rate policies if you don’t have a strategy in mind. That is because announcements regarding interest rates, inflations, and company earnings instantly sway the direction of the markets. Options trades must be cautious in such scenarios, as a drastic turn can instantaneously eat up their profits. So, it’s important to regularly review market news and analysis and to be aware of any potential events or developments that could impact your trades.
- Avoid Letting Your Emotions Take Over You
As a trader, it is essential to be aware of your own biases and to make sure that you’re not letting your emotions influence your trade decisions. When you let your emotions take the driver’s seat, many traders become overconfident or desperate. A trader may feel overconfident when they are on a winning streak. On the other hand, they become desperate to land a win when things are not working out in their favour. Both overconfidence and desperation can lead to overtrading, impulsive decisions and a lack of risk management, which can be costly. The market is always dynamic, and even the best traders can fail; sometimes, it’s best to take a break.
- Avoid Concentrating Your Portfolio
Overconfidence can lead to another mistake—portfolio concentration. However, it’s important to be mindful of your own limitations and approach options trading with a healthy level of scepticism and caution. Concentrating your trades on a single underlying asset or strategy can increase your risk and expose you to potential losses if that asset or strategy doesn’t perform as expected. So, it is best not to put a large chunk of your capital in one trade. When it comes to options trading, you can consider taking a position across 2-3 assets or using different options strategies.
To conclude, as an options trader, all the outlined points mentioned above indicate one thing—don’t gamble with your money. Options trading is not gambling, but it involves following a set of rules to maximise your profits and minimise your losses. Moreover, it’s also essential to understand the potential risks and rewards of each trade, including the potential for loss and the potential for profit. A solid online stock trading app can help you plan your strategies and analyse your trades. And lastly, if you are new to the stock markets, learn about options, but consider staying away from them until you understand the other fundamentals of stock trading.