Options trading can be a good way to manage your risk, as well as to take advantage of a stock's upside potential with less required capital. However, there are some options trading mistakes to avoid -- particularly when it comes to making and managing risky, complex, and speculative trades.
Buying out-of-the-money options as an investment
As of this writing (June 9, 2016), Apple stock trades for just under $100 per share. And, I can buy options to buy the stock for $110 at any time before August 19, 2016, for $0.80 -- or, $80 per contract to buy 100 shares. If the company has a great summer and rises to $115 by expiration, those options will be worth $500 per contract, a return of 525%. However, if the share price stays below $110, they'll become completely worthless.
Now, there is nothing wrong with doing a bit of speculating as long as it's money you can afford to lose and you know you're taking a gamble. One mistake new option traders often make is buying out-of-the money options with large sums of money, hoping to pocket some huge gains. More often, however, they lose it all.
Unless you're using them to hedge another investment, or you're buying them with money you'd also be willing to take to a casino, I recommend avoiding out-of-the money options until you really know what you're doing.
Not having a goal in mind
When entering into an options trade, regardless of whether it's a simple or complex one, you should have a clear goal and exit strategy in mind. When doing something simple like selling a covered call against a stock position you own, the goal can be something like "the call will expire worthless and I'll keep the premium."
And, you should have an exit strategy you're ready to deploy whether the trade goes your way or not. With the covered call example, if the trade is working out favorably, the exit plan may be to simply wait until expiration and then write another covered call. If the stock price starts to rise, you need to decide whether you want to let your shares get called away, or if you want to roll it into a longer-dated covered call.
Obviously, for more complex options trades, there are many different scenarios that could happen, so your exit strategy can (and should) be significantly more complex than this example. However, the point is that a solid goal and exit strategy can help you lock in gains and mitigate losses -- in other words, it takes emotion out of the equation.
Doubling down on losing trades
This is one that I've been guilty of at times in the past, and there's really no excuse for it other than a lack of discipline. If you place an options trade and the stock's price starts moving against where you want it to go, it can be tempting to throw more money into the trade to attempt to get back to even.
This is especially true when simply buying call options. For instance, if you buy $40 call options on a $45 stock, and the stock falls to $35, it may be tempting to add some (now out-of-the-money) calls to your position. After all, the options are probably much cheaper right now, and if you liked the stock at $45, it might seem really attractive at $35.
As I pointed out in the first section, buying out-of-the-money options is rarely a good idea. This is doubly true when you're putting in more money than you originally planned.
Forgetting about dividends
Sometimes, options on companies that pay high dividends may seem cheap. There's a good reason for this -- the options don't entitle you to any dividend payments. So, make sure you take this fact into account when evaluating options prices, especially when using options as a stock-replacement strategy.
For example, let's say that you want to invest in AT&T, but you don't want to tie up the money required to buy 100 shares. So, you buy a $30 call option expiring in January 2017 for $9.80 ($980 for one contract), which is almost exactly the difference between the strike price and the current stock price. Well, if the stock price remains the same until expiration, so will the value of your option. You'll have no gains at all.
On the other hand, if you had purchased 100 shares, you would receive three dividend payments between now and expiration. Since AT&T's dividend is currently $0.48 per quarter, this translates to dividend income of $144 that shareholders get, but option holders don't. I'm not saying that using options as a stock-replacement strategy is a bad idea -- in fact, I do it regularly. Just remember to take dividends into account when you're doing your research.
For those new to options trading, the best piece of advice I can give is to take it slow. Don't put too much money into any one trade, don't make speculative bets and consider them "investments," and have a clear plan of action when entering into a trade. Start off with basic strategies such as covered call writing and deep in-the-money call and put buying as a stock-replacement strategy. As you learn the ins and outs of options trading, you can add to your arsenal over time, when you're ready to do so.
Matthew Frankel owns shares of Apple and AT&T. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.