New option traders can make many mistakes when they first start trading options. Here is a quick list of what to do and what not to do as you come into the options market for the first time.

Are Options Good for Beginners?

"Fish see the bait, but not the hook; men see the profit, but not the peril." - Chinese proverb.

Options can be both a great wealth-building tool and a quick way to lose all your trading capital if you overleverage your trades. Disregarding the odds of your option trade winning can lead to outsized bets that leave zero dollars in your account.

Option contracts can go to zero by expiration or rise 100% right after entry. Option traders must always manage for both possibilities based on an option's probabilities of movement by expiration. The Delta of an option is a good indicator of probability; it is part of the option pricing model.

An at-the-money option will have approximately a .50 Delta as it can move equally in either direction. A deep-in-the-money option will have a Delta near 1.00, as its price moves with the stock price dollar for dollar. An option far out of the money can have a 0.10 Delta if it has approximately a 10% chance of going in the money by expiration. Delta for an option contract can approximate the odds for new option traders and help them choose their position size carefully.

Options can be used to overleverage and blow up your account with big all-or-nothing bets. Or they can be tools for asymmetric risk management, allowing you to deploy only small amounts of capital while capturing full moves in your favor.

Options are also tools that professionals use to hedge their stock positions and limit downside losses. Here are what I believe are the seven biggest mistakes new option traders may make if they are not familiar with how options work.

What should you not do when trading options?

Too often, new option traders become obsessed with buying far out-of-the-money options without fully understanding how heavily the odds are stacked against them. They become gamblers looking to play the lottery. If the Delta is 0.10 or less, then you have less than a 1-in-10 chance of your option expiring in the money.

Even if you get a move in your favor, your far out-of-the-money option will not increase in value until the Delta expands enough to overcome the time decay. It takes a significant price move to increase the value of out-of-the-money options. The odds of it expiring in the money have to increase enough to drive up the contract price.

New option traders can become frustrated when the price moves in their favor and their out-of-the-money option goes down in value! The delta must expand faster than the time value decays. Options with at least a .25 Delta will double your odds of success a lot, from a 1 in ten chance of profit on expiration to a 1 in 4 chance of being able to go in-the-money and grow quickly in price as the delta expands more easily with a move in your favor.

Also, an option trader doesn't have to wait until expiration; an option can be sold to lock in profits at any time in its lifespan. Most of the time, it is better to lock in option profits while they are there and not get greedy for more gains. Option contracts are deteriorating assets, and time is not on the option buyer's side.

Many new to options don't understand that you cannot trade options on all stocks; you need open option volume to create liquidity, so options have a tight bid/ask spread. It's not wise to trade illiquid options because you can lose 10% or more of your capital in a position just in the entry and exit of your trade. If there isn't enough volume to tighten this spread, executing option trades can be expensive.

Look at how much it will cost you to enter and exit an option trade before trading any option chain. You want to see option spreads of a dime to fifty cents, preferably. A dime bid/ask spread on an option will cost you $10 to enter the trade and $10 to exit. A 100-share contract times $0.10 per share equals $10 each way. This is a $20 round-trip ticket in addition to your commission fee, and it applies to only one contract.

A $1 bid/ask spread will cost you $100 in slippage to get in, and then $100 or more to get out of a single contract. This is a trading expense that compounds over time. The moment you enter a one-contract option with a $1 bid/ask spread, you are already down $100 with the slippage. Only trade in the most liquid option contracts on the leading stocks and stay away from the low-volume markets that will slowly eat away at your trading capital through slippage.

Always buy an option that aligns with your trading time frame. Give your trade enough time to work. If your plan is for Apple to reach $200 in 1 month, don't buy a weekly $200 strike call; you'll run out of time, and it will expire worthless. Buy at least a monthly out-of-the-money option that will not expire before your trade has time to play out. With options, you have to be right about both the price and the time frame; being right on just one is not enough to be profitable. You can be right about the price but run out of time on your option, or you can be right about the move but buy an option too far out of the money or too expensive to profit from the move.

It's crucial for option traders to understand that implied volatility is priced into options above normal time value before earnings announcements or other uncertain news events, and that the Vega premium is priced out of an option after such events are over.

If an at-the-money weekly Apple call option and put option are trading at $10 above normal time value on the day before earnings are announced, the day after earnings, that $10 in Vega value will be priced out of the option contract. The option trade is only profitable if the intrinsic value of the option going in-the-money at the strike price chosen is more than $10 to replace the lost Vega value.

When trading through a volatile event like earnings, you must be right about the magnitude of the price move to be profitable; the direction alone is not enough. You will see that buying options through earnings has a low probability of success because option sellers build in plenty of Vega to cover their risk. It's very difficult to overcome this Vega collapse. Many will tout the few times the move was not priced in, but that is a low-probability event. Short straddles can be more profitable in earnings than one-sided long directional option bets due to the volatility crush.

With in-the-money options, you take on the risk of intrinsic value, but you only have to be right about the direction. In-the-money options have little Theta or Vega; they are almost entirely intrinsic value. With very high deltas above .90 and sufficient liquidity, deep-in-the-money options can be used as one-sided synthetic long stock positions, but without the same level of downside risk. Deep-in-the-money option positions also require less capital to achieve the same leverage as a stock position.

Don't risk more with options than you would while trading stocks. Never risk more than 1% of total trading capital on any one option trade. If you can only trade 100 shares of Apple in your trading account, then only trade 1 Apple in-the-money option contract. If your trading capital is large enough to handle trading 1000 shares of a stock in your normal stock trading account, then trade 10 contracts of those options.

Don't trade too big with options; while they can double and triple in price, they can also go to zero. Options can move so fast that it's difficult to use stop-loss orders on the option price itself. It's much easier, as an option trader, to treat option trades as all-or-nothing with small positions in most cases. A 50% stop loss on an option is the best you will likely be able to manage a lot of the time with most option plays. Stop losses have to be on a stock chart where they have technical meaning, not at a random option price level. This is why I prefer all-or-nothing option trades and using the stock price.

Unlike stocks, which represent ownership in a company, options are derivatives of stocks and are simply contracts that expire. They are not assets; they are bets. Options are a zero-sum game; there is a winner for every loser in the options market. For every option contract bought, someone wrote that contract. When trading options to be on the winning side, you always want the odds in your favor. If you are a seller of premium, sell the out-of-the-money options that have little chance of being worth anything.

Option buyers can buy in-the-money options to go with the current market trend. Option premium sellers can sell to open put options supported by the hottest stocks during bull markets and sell calls on stocks in downtrends. Avoid the temptation to pay high premiums for selling puts on volatile stocks and calls on growth stocks during strong trends, as this can be dangerous.

With options, don't buy low-probability, far-out-of-the-money lottery tickets; sell them. Don't cap your upside on a hot stock by selling a covered call; instead, buy a call option to capture the upside with a smaller position size. Be on the right side of the probabilities, manage your risk, and you will do very well over the long term with an option strategy that has an edge.

Approach your option trading like a casino operator, not a gambler. Set bet size limits for yourself. Understand and respect the odds of success for any trade, and carefully manage your maximum risk exposure for every options trade.

Don't try to get rich quickly. Your first priority is to conserve capital in your options trading account by making small bets. When you start trading options, strive to make small mistakes, not big ones. There is always someone on the other side of your option trade, so trade carefully. It's not easy money; it's a game you have to play better than other traders.

11 Options Trading Tips

1. Short options have theoretically unlimited risk when they are unhedged.

An unhedged short option contract has its reward limited to the price at which the contract was sold, but the price can go to any level, creating unlimited risk exposure if it lacks a hedge or a stop-loss set at a buy-to-close level. It can be very dangerous to hold a short option contract without a hedge in place, as it carries unlimited risk. Professional option traders almost always hedge short options with a cheaper long option contract or the underlying stock.

2. Theoretical option trading is not the same as trading with real capital at risk.

Learning about option Greeks, option plays, and trading them with real money at risk are very different experiences due to ego and emotions. Research, study, and simulations don't carry the risk and uncertainty that come with the potential to lose real capital.

Be prepared psychologically for the stress, emotions, and ego that you'll experience with capital at risk; don't let the rush of feelings take you by surprise. Start with small position sizes and work your way up to larger sizes over time. Be ready to manage your mind, emotions, and thoughts in the options market.

3. Trade your option strategies consistently, but adjust to the price action.

Trade your system based on your own parameters and signals, but don’t blindly take the same types of risks across all market environments and charts. The current directional market trend in price action and the level of volatility adjust position size and directional bias to stay on the profitable path of least resistance on the chart.

Not all market environments are suitable for all types of option plays. Know the difference.

4. Liquidity is the first fundamental filter for options trading.

Only trade options with the highest volume of interest so you don't lose a large percentage of your capital on the bid/ask spread when entering and exiting trades. You must trade on option chains with sufficient liquidity, using spreads measured in cents rather than dollars. A $1 price difference in the bid/ask spread will cost you $100 to get in and out of a trade, in addition to commissions.

The best liquidity is in front-month, at-the-money options, and option chains become less liquid as they go deeper in-the-money or out-of-the-money. Moneyness must be considered in a winning trade because you might have to roll the option into a more liquid contract. Also, the further out in time to expiration you trade, the less liquid options become, with wider bid/ask spreads. Most option chains can't be traded because they aren't liquid enough.

Stick to the leading stocks with the most liquid option chains; it's easier to get in and out and avoid the costs in the spreads.

5. Don’t let a losing option trade get out of control.

Define your risk in every option play before you enter it, whether long or short. Set limits for risk of capital as well as delta, gamma, and theta exposure. Regardless of the option play, manage the risk exposure by exiting long option positions, moving hedges, rolling options out in time or strike, or closing option legs. Always be aware of the risk-to-reward ratio in an options trade, and exit when the actual risk is no longer worth the potential reward.

6. Know how to lose quicker on an option trade.

A losing option trade should have the loss capped at the hedge or at the stop-loss level on the stock chart. An options trader should never lose more than 1% of their total trading capital on a single option trade. Most long option trades should have a position size of at most 2% of total trading capital.

The stock chart is more meaningful than the option price for identifying a technical price level. Long option risk must be managed primarily through position sizing, as options can go to zero. Don't trade too big or let a losing trade get out of hand; know where you are getting out before you get in.

7. Diversify your watchlist of stocks, types of signals, and option plays.

An options trader needs a diversified watchlist of option chains to trade different types of plays based on the current market range and trend. The more types of trading edges with options you have to execute, the greater your odds of success through different types of market environments. Multiply opportunities with multiple edges based on math and probabilities.

8. Keep your option trades as simple as needed.

An options trader doesn't need to create complex 4-legged option trades to make money. A trader only needs a repeatable edge to profit from the options market. Complexity can add risk and unnecessary trading activity. All that matters with options trading is probability, volatility, repeatability, profitability, and the quantified risk/reward ratio. Profitable options trading can be simple. The edge is all that matters. Your wins just need to be larger than your losses on average, or you need a high win rate with small losses.

9. Patience can be an option seller's edge, but an option buyer's weak spot.

An option seller benefits from time decay, as theta continually erodes the option's value, and can let the clock run out on the option buyer if the move is not in the buyer's favor. The option buyer doesn't have the luxury of time, as they must be right about the direction and magnitude of the price move, as well as the time frame in which it will occur. Time is the option seller's friend but the option buyer's enemy. The direction and momentum of the price trend determine where the pressure is until expiration.

10. Anything can happen in the markets at any time.

Always accept that anything is possible in the markets at any time. Don't think something has to happen or that a market can't go any higher or lower after a long trend in one direction. Think in probabilities and possibilities, not certainties and strong convictions. Option traders must stay open-minded about all potential outcomes and accept reality as it unfolds.

11. Never expose yourself to the sudden risk of ruin with too many open-ended and unhedged short options.

One big risk event can wipe out all your gains at one time. Hedges are cheap insurance against ruin. Always manage risk through proper position sizing with long options, proper hedging, and stop-loss orders with short options.

Many option traders have been ruined when what they thought was impossible happened; some examples are the Lehman bankruptcy of 2008, September 11, 2001, and Black Monday, 1987. Option traders were ruined on these dates when they failed to hedge their short option risk or were simply overexposed to long option positions.

The best option traders are more like mathematicians and statisticians than emotional gamblers.

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