August 27th, 2021

Don't Be Fooled: How to Avoid the Common Errors of Options Trading

When done right, a good options trading strategy can be an effective way to diversify...

When done right, a good options trading strategy can be an effective way to diversify and grow the value of an investment portfolio. Using tools like an options profit calculator can greatly improve your odds of success during your trades.

An option is a contract that provides the holder with a right to buy (call) or sell (put) a particular asset at a certain price point, before a specified expiration date. In essence, an option is a bet on the future value of an asset that you can leverage into a profit through the right to buy or sell it. The asset could be any number of financial products – such as a stock, bond, commodity, index, ETF, or mutual fund.

Options contracts are known as derivative assets because their price comes from the value of the underlying asset. Like other financial instruments, options carry their own benefits and risks. We’ve prepared a brief guide to help you understand important concepts for building your options trading strategy and how to avoid common errors for entering this asset class. 

Know How Options Trading Affects Your Finances

Options can be risky. This is because of the many factors that can drive the value of an underlying asset. Before acquiring any options, you should consider the capital you are using and how it impacts your entire financial picture. 

In theory, you should only place money that you can afford to lose into an option contract (i.e., don’t spend the money that you need to pay the bills in the short term). For example, you may wish to only expose a few percentage points of your net worth into options. Avoid the mistake of treating options as a get-rich-quick scheme instead of one piece of a healthy investment portfolio

Understand the Financial Commitment of the Option

The holders (i.e., buyers) of an option do not have to buy or sell the underlying asset. They just have the right to do so. This means their only financial obligation is the price of the premium to purchase the asset. In contrast, the writers (i.e., sellers) of an option tend to have more financial exposure and risk. This is because of the possibility that the holder will exercise their option and require the writer to buy or sell the underlying asset. 

Consider the Tax Liability of Your Options Trades

Trading an option will likely result in a tax event that generates a gain or loss. In the case of a trade at a profit, you might have a short-term or long-term capital gain. The cost-basis and sale price will determine the amount of taxable income. The length of time you held the asset will influence the effective tax rate on that income. 

We recommend working with a trusted tax advisor to understand the tax consequence of options trading with your other tax liability. Taxes are the cost of a successful trade, and you should consider them to understand the big-picture value of your option trades in a given year. 

Develop an Options Trading Strategy

With a clear picture of how option trading fits into your financial game plan, you can develop a strategy. As the name implies, an option provides you with choices that you can use to maximize your overall investment strategy. 

These strategies will vary based on your age, income, and financial goals. More importantly, having a strategy beforehand can prevent emotional and irrational decisions with options that can lead to catastrophic errors. 

Regardless of your specific goal, the options you choose should reflect your strategy with special attention to two aspects. 

The Nature of the Underlying Asset

Researching and understanding the fundamentals of the underlying asset is important when taking an option position. All assets have unique characteristics that affect their price. We are talking about industry trends, market participants, regulatory efforts, and other price-altering events (e.g., earnings reports, M&A deals, natural disasters, political elections, etc). Consider these details when selecting an option. 

The Option’s Expiration Date

The expiration date defines the period in which you must either exercise the rights under the option or trade it. Several issues can arise in selecting an option with an appropriate expiration date. For example, you have the potential for different tax consequences. Short-term options will have short-term gains and losses, and long-term options have the potential for long-term gains or losses. 

Options are known as time decaying assets because their value tends to decrease the closer you get to the expiration date. The reason being that it becomes less likely the price will fluctuate as you near expiration. Develop an exit strategy in advance, so you know when to trade or exercise your rights under the option to avoid an expiration date limiting your choices. Also, consider the timing of price-altering events during the term of your option that will influence your exit strategy.

Be Aware of Important Metrics that Impact Your Options

The fun of options is using various market data points to make informed opinions about the future prices of assets, to generate profitable trades or underlying asset purchases. With options, you have two markets to follow and pull data from – the underlying asset market and the option market. Some key metrics and calculations to incorporate into your option trading strategy include: 

  • Market Liquidity: This is a measurement of how active a market is (i.e., the number of buyers and sellers that drive transactions). Avoiding options with an illiquid market is a good approach to prevent a situation where you cannot find a buyer for an option you are trying to offload. Additionally, liquid markets often result in parity between the bid and ask price of an option.
  • Market Volatility: A measure of the expected price fluctuations for an underlying asset. Volatility is a key factor in option trading because it affects the price of the premium for the asset. The premium should influence your opinion of the option and whether it fits within your trading strategy.
  • Options Profit Calculations: Understand the potential value of your option position when evaluating option targets and subsequent trades by using a profit calculator. A good option profit calculator can quickly model scenarios to find the right risk/reward option for your investment goals. A calculator that uses real-time data is equally important for analyzing trade value within your option’s expiration window.   

How Can Elevate Your Option Trading Strategy 

At Vig, we provide over 1 billion U.S. stock, ETF, mutual fund, options, and futures data points at any time – with no delays – from the world's most trusted industry providers. We offer these rich data points to our customers through a variety of market tools. Our purpose is to empower your investing experience

Our creators focus their development of our platform with two goals in mind. The first is to produce intuitive web and mobile applications that are easy for you to navigate and read.  Second, they aim to use their proprietary algorithms to synthesize data points into fresh trends and strategies for your option trades.  

In addition to market tools and proprietary alerts, you will also have access to our daily stock games, where you can test strategies without risk for a chance to win cash prizes.

Sign up for a free account today with basic tools and purchase access to our advanced analytics

Common Options Mistakes