You can’t take the risk out of options, but you can do your best to limit it.
Options trading used to be reserved for professional investors. But the simplification of platforms has really opened up the market — whether you wear suspenders and have three computer monitors on your desk or not. With options, you can do more than just buy or sell a stock. You can take a very specific position, like how much a stock will move and by when, and it costs you less than it would to buy the underlying stock.
The big problem? Options are complicated, and a lot of people are great at trading them. In fact, they downright stink: one study found that retail traders lost US$2.1 billion on options in less than two years. We don’t want you to stink at trading options.
The first step to not stinking is educating yourself. We have a deep-dive, not-at-all-boring primer to help you do that. The second step? Avoiding the following mistakes.
Mistake #1: Forgetting you can lose it all
A lot of us are used to the way stocks move. They rise and fall — sometimes like a gentle ocean wave and sometimes with the jerky urgency of a lie detector test — but they rarely drop all the way to zero the way options can.
Let’s say you want to buy a call option on a stock called $KALE. (For a glossary of options terms, click here.) One share costs $200 today, but you think it’s going to go up.
So you buy an option that gives you the right to buy 100 shares of $KALE for $220 each (called the strike price) two months from now, no matter the market price. If $KALE never gets higher than $205, unless you can find some optimistic person to take the option off your hands before it expires, you can be left with… nothing. The lesson here is similar to the lesson for crypto: never invest money you’re not willing to lose.
Mistake #2: Paying attention to the direction a stock moves in, but not how much it moves
Buying options is like betting a friend that you’ll beat him by three in a pickup basketball game. You can win by two and still lose the bet. Don’t like basketball metaphors? Back to $KALE! Say you had a good feeling that the company was going to announce big news the next day. You could buy a one-day option that paid off if shares went up 30%. If, after the big announcement, $KALE shares rose 23%, regular investors would be thrilled, but not you. Even though the underlying stock rose drastically, it didn’t rise enough. As a result, your option would’ve lost most, and probably all, of its value.
Mistake #3: Not realizing shorter-duration options increase the risk of losing everything
Like milk, at some point all options expire. It could be six months from now, two weeks, or even just a few hours. And while the option’s value changes throughout that period, the closer you get to expiry, the higher the odds the option loses all of its value. This is why zero-day-options (options that expire the same day they’re issued) are so risky.
In the first $KALE example, you have a 2-month option to buy $KALE for $220/share. If the stock price falls from $200 to $180 the day after you buy the option, the value of that option will fall, but probably not by too much. That’s because there’s still plenty of time left for the stock to recover. If you’ve got only one day before the option expires, however, that same fall in stock price will tank the value of the option. There’s just not enough time to reasonably expect the stock price to recover.
Mistake #4: Buying short-term options with long-term expectations
A lot of cheaper options tend to have shorter windows. Something has to happen quickly for them to hit their strike price — which makes them risky. That’s why investors often buy them only when they have specific expectations of something happening that would move the underlying stock within that window. Again, back to $KALE: if you buy that one-day call option that pays out only if the stock price goes up 30% or more, you really should have a reason. A specific one. Having a good feeling about the CEO’s general abilities as a leader is not a specific reason. Seeing clues that they’re about to, say, announce a big money-saving reduction in the company’s workforce is. The more general your feeling, the safer you are with longer-term options, which give those feelings more time to come true.
Mistake #5: Thinking you can find a buyer for any option
If you can dream up an option, someone will sell it to you — even if it’s stupid. For example, say you think $KALE’s stock price will go from $200 to $400 in two days. Never mind that it’s never hit $400 and it’s certainly never doubled in two days. You have a feeling! Well, someone will sell you that option. But before you buy it, you need to realize how hard it might be to sell again. And that lack of demand means you’re going to get a really low price for it — if you can find a buyer at all.
Mistake #6: Letting an option expire when you don’t have the funds to exercise it
Most retail investors sell their options before expiry. They get in and get out, and make or lose money depending on the value of the option when they sell it. But you also have the opportunity to hold the option until it expires and buy the stock at your preset price.
In the case of the $KALE example above, buying 100 shares of $KALE at $220 (called exercising the option) would mean coming up with $22,000. Yes, you could sell the shares immediately and collect a profit of $20/share, but only if you had enough money to buy them first.
If you are holding an option when it expires and you don’t have the funds to exercise it, you are out of luck. You make no money, and just to make things worse, you’ve also lost whatever you paid for the option. That’s why you should always pay attention to an option’s timing, especially when you’re dealing with shorter-durations — the most extreme being those zero-day options. It would be a real gut punch to make the right call and still end up with nothing.
