Top 6 mistakes that option trader makes

Options are lucrative. What makes it lucrative is the volume and liquidity, it brings in the market. Almost 82 per cent of the volume in the equity markets, both in indices and stocks, comes from options. That is what attracts many people whether individual or institutions towards option trading.

The retail traders especially new traders believe option trading is the quick way to be rich. So, they are generally attracted by saying limited risk, unlimited profit. The saying plots a partially incorrect story before them. The multi-bagger return is possible in Options trading in a day or a month but it only happens when you select option strikes for buying precisely and your selection is supported by momentum and goes right. Otherwise, you may lose your entire premium.

Mathematically, option buyers have 10 per cent chance to make profit and rest 90 per cent goes against them. So, the multi-bagger returns are there but 10 trades out of 100 favours you.

On the other hands, the big players have a different path to traverse. They avoid naked option buying instead they love to sell those options. They are happy in limited returns and they continuously come victorious. Their victory is supported by the fact that 65 per cent of the options traded worldwide expires worthless. That’s the reason they go for selling option however, selling has unlimited risk and limited profit.

Thus one would most likely find a retail trader buying an option where the return could be unlimited but the probability is low. But a big players would typically be taking the other side of the trade where the return is limited but the probability is very high.

The question is, how the retail buyers of the options become the member of 10 per cent club. One way to ensure success is to avoid the most common mistakes. Here are a few mistakes an option trader makes which pulls him down.

Luck of Knowledge
Many retail traders jump into options trading due to the attraction of infinite gain. They are generally supported by their beginners’ luck. So, they don’t bother to understand the reason behind the movement of the option or the maths that makes it move. They pay little attention to the details like how much an option moves concerning the change in underlying or index price. They don’t know what Greeks are and how they control the market. Even, they don’t know which strike offer him a good Risk and rewards, in a small move or in a big move.

Buying inexpensive Options
The inexpensive options are the out of the money options, due to lack of proper knowledge about options, retailers tend to buy an out of the money calls or puts for the simple reason those options are cheap. The beginners’ luck or occasional favoured trades make retailers to buy OTMs every now and then. In most cases even they are right still they lose the money because momentum fades that it needs to become profitable. It is a well-established fact the trading in OTM, brings loses.

Lack Of Exit Plan
The one thing that you must have in your trading - the exit plan. Trader who knows when to exit has an edge to win the trade. Holding an option, more than required can erode the premium. An OTM needs a big move for furnishing you profit, if it does not come in time, better you should exit the trade otherwise you will lose the entire premium.

No Clue about VIX
The one thing that affects the most to the option traders is the Volatility or Implied volatility - The index of volatility is known as the VIX. Most of the option traders are ignorant of the VIX. They don’t know the killer use of Volatility in option trading. When Volatility increases or decreases, it makes a great effect on the premium that surprised an option traders.

No Proper Risk management in option Writing

Generally, retail option traders don’t come in option writing as it needs huge margin. However; there are few broker like Astha Trades offers lucrative margin for retail option sellers in index. They allow you to write an index option with a margin of Rs. 3500.

One thing that I would like to mention that option writing is not a holy grail. It has unlimited risk but limited profit with a high probability of winning. So, if you are interested in writing an option, you should manage your risk by hedging it or keep your stop loss tight - if a trade goes against you, it can wipe out the months' gains. Yes, one wrong trade-in option writing can erode your entire capital. So, trade with proper risk management.

Care for Time Decay
Another big factor, that consistently, goes against a retail trader is Theta - the time decay. An option has premium and premium depends on the intrinsic value and Time value of the option. Due to time value, most of the traders find themselves in the losing ship during the expiry.

The Bottom Line

For trading option, one needs proper knowledge and understanding about it otherwise it could turn to be a big money burner for a trader. However; if it is traded with good skill and understanding could turn to be multi-bagger.

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