Top 10 options mistakes

There are as many ways to lose money in the options markets as there are traders. Some mistakes, however, are repeated over and over again. Here are the 10 most common ways traders lose it all, together with some basic advice on how to avoid those mistakes.

By John A. Sarkett, developer, OptionWizard Scan software

Every now and then we hear how famous traders get blown out of the market, usually because of a mistake that with a little help of hindsight should have been easily avoided. But anybody who has placed an options or futures trade knows that whether you're a seasoned pro or a beginner, it's never too late to make that fatal mistake in the fast-paced markets. Here are 10 common examples of traders and their dooms-day mistakes. If you recognize yourself, hopefully you've corrected the problem and carried on. If you don't, be forewarned -- these seemingly simple mistakes have tripped up the best.

I have a $45,000 options account, and I need to make $100,000 per year from it. I believe I can do it because I quit my job, attended seminars and will work full-time at it. Besides, I am very smart, very successful and was the youngest graduate in the history of my law school.

This is the Unrealistic Expecter. Often successful in a previous life, he expects to be successful in options but without the requisite training or skills.

After spending a small fortune on seminars and despite warnings from others about how successful and energetic individuals may encounter problems when switching their focus to the markets, which rewards passivity, a professional quits his law practice to trade options. He springs into action on tips from his seminar gurus, trades without stops and expects the market to fork over big profits because he is on the scene and has always won. At the outset, he experiences the worst outcome possible -- he starts winning. But soon enough, the tide turns. Buying outrageous volatility, his long positions -- and he is only long -- decline until his capital expires.

This story is repeated hundreds of times each day. To avoid it, set a realistic goal, for example, 10% to 30% per year of your trading capital. If you can beat the S&P 500 consistently, you will be in the top 20% of professional fund managers.

I get all my ideas from _____ (fill in the blank with your favorite guru, advisory service or broker).

This is the True Believer in Gurus. This person prefers a black-and-white world. Shades of gray unsettle him. From time to time you may hear him ex-claim: "This has to be so -- it says
so right here in black and white."

Instead of developing a well-informed opinion of the markets, it is much easier to buy a subscription to a newsletter, Web site or fax service. This approach also provides a scapegoat when things go wrong. And things do go wrong, for advisors as well as individual traders. In the fast-moving options world, this is a special danger. For instance, if you had followed Barron's bearish posture through the 1990s, you would have sat out or shorted the biggest bull market in history. But the solution is simple enough: Do your own work and don't rely on so-called gurus!

I trade whenever the opportunity presents itself. You have to play to win, right?

This is the Overtrader. He knows that if you try hard enough, you've got to succeed. But like a martial arts master, the market uses this otherwise positive trait against him.

A famous seminar guru counsels customers to bring a cell phone to the meeting because at the break they will call their broker and make a trade. But how do you know there is a trade to be made at 10:30 a.m. on Tuesday? How do you develop and test a system you trust in between registration and the break? Also, a lot of so called "opportunities" just aren't.

In Reminiscences of a Stock Operator, the legendary speculator Jesse Livermore says he made most of his money sitting. Investment biker, CNBC host and Market Wizard Jimmy Rogers puts it this way: "I don't trade until I see a pile of money sitting in the corner. Then I go over and pick it up." And: "I don't think of myself as a trader. I think of myself as someone who waits for something to come along."

I really don't need to know much about the stock -- if the option is moving, that's all I need.

This is Mr. Twice Smart. He knows that because everyone knows about the big, successful stocks, the real answer must be in the little, unknown stocks.

Many losing traders are in small stock option positions. If the world doesn't know your stock, the world is not going to move in, buy and push it higher. Better to follow Microsoft or Intel than the software wannabes. Better to follow Lilly, Pfizer or Merck than a biotech that is perpetually on the brink of having a product approved. Microsoft, Intel and Lilly are real companies with real products and real earnings. Millions, not hundreds, follow the stocks. When the companies move, the institutions move and the stocks move.

I buy the option when there is news on the stock.

This is the News Call Buyer. He doesn't understand the volatility component of options -- he believes stock and options prices always are linked and move in lockstep. The problem is typically the next day the stock goes down and the option collapses.

This is an extremely popular approach. News services now sell pagers to alert you to financial news wherever you are. Unfortunately, buying on the news opens a Pandora's Box of trading issues: News increases volatility, which in turn increases options prices. There are two kinds of volatility. Historical volatility is a measure of how much a stock may be up or down one year from now based on past price movement. Implied volatility is the same measure but is based on the current option price. High implied volatility typically regresses to historical levels. That means after the news, the stock can stay the same or decline slightly while your option can collapse.

There really is no time to follow the technicals of a stock or to bother with options analysis such as volatility, delta or in-the-money probability when you're trading options.

For Mr. Gotta Move Fast there's no time to plan a trade. If the broker or guru speaks, he must act immediately or lose out.

Too many losing traders don't know what the technical situation in the stock was when they bought the option. But by having a clear understanding of the trend, momentum and the volume pattern, you can put the odds in your favor. You can buy a call when a stock is moving out of oversold support with a positive volume formation or, conversely, sell a call or buy a put when a stock is overextended.

Using an options calculator, it shouldn't take more than a minute to calculate volatility and delta. Implied volatility is, in effect, the option's price. You must compare implied to historical volatility to know whether your option is fairly, over- or underpriced. And don't just concentrate on what can go right, consider what can go wrong and make sure the odds are in your favor. When you trade, make it your trade with fundamental, technical and option analysis, with your target profit and your stop loss. Treat your wins and losses the same, and in time you will succeed.

I always buy out-of-the-money options because they are cheaper and you can buy more of them. I never sell an option -- that's too risky.

This is the Bargain Hunter. For him, an option that loses half its value in one week is not risky because "you know how much you can lose."

Those out-of-the-money options are cheap for a reason. They have a low delta, which means that the price of the option will change very little when the price of the underlying changes. They also have a low probability of being in-the-money. One of the advantages you have as an options trader is strategy. You can employ leverage, time, expiration and limited dollar risk as friends or foes. Consider, for instance, these alternatives:

If your capital is limited, one option is an at-the-money call debit spread. (For example, for a $40 stock, buy the 40 strike, sell the 45.) Or for a put credit spread, you could sell the 40 put and buy the 35. Not only will these strategies give you a lower entry price but a higher probability of success as well. The tradeoff is that they will limit your maximum profit potential. If you own the stock, you can sell the call to collect additional income. But you also can sell the overpriced premium just before expiration with a high probability of success.

I buy the calls when a stock splits because I know the stock has to go higher.

This is the Split Buyer. He knows that if a stock splits, it has to go higher every time.

In a raging bull market, this play has become a favorite. It also has become a somewhat self-fulfilling prophecy but less so each time because there is no fundamental reason why a pie cut into eight pieces instead of four is worth more. But when a stock splits, the calls usually become quite expensive because buyers rush in, bid them up, increase implied volatility and the call price. The next day, when volatility returns to normal, the calls decline.

If the stock is not a stalwart, consider fading the split by selling calls or buying puts. Only buy calls if you have other fundamental and technical reasons for doing so. Be sure your options are fairly priced, with a delta of 60 or more.

I don't like to put in a stop loss or trailing protective stop. I might get stopped out. I'll just "watch it."

This is Mr. No Stops for Me Please. But he really should be called Mr. No Stops for Me Because I am Unwilling to Lose Any Money.

Carrying losses will hurt you in several ways. Not only will it deplete your financial and emotional capital, but it also will cause you to miss other big opportunities while you're wishing and hoping for your position to come back.

When you have a winner, insert a protective stop. Options are so leveraged that if your position falls back, it likely will continue much lower. Better to take half a win than to turn a winner into a loser. Otherwise, it's very hard on the psyche. Turning a winner into a loser invariably will create a "get even" mentality that will lead to further losses.

Alex Jacobsen, vice president of the Chicago Board Options Exchange puts it this way: "Like a successful gambler, you must learn to ante and fold. Ante and fold. Ante and fold. Occasionally, double up to win big."

If it weren't for (insert guru, advisor, author), then I would be successful.

This is Mr. It Wasn't My Fault. This is the one of the last comments you hear before he is forced to leave the game.

Don't blame anyone else for your trades. If you choose among great companies with expanding earnings (or the reverse for the short side), analyze the fundamentals, technicals and options (fair value, volatility, delta, probabilities), make your forecast and treat options like the business it is, you will have a greatly improved chance to succeed -- on your own, with no need to blame or credit anyone else. You will have turned options into a satisfying business enterprise instead of a bedeviling game.

John A. Sarkett is a trader and the developer of Option Wizard® Scan and author of
Option Wizard Trading Method,a companion publication. He writes on financial markets, trading, and options.