Here is a harsh truth: Not all investors succeed at creating a profitable portfolio. Sometimes this is due to the unpredictability in the market or various other factors, but more often new investors fail because they lack a solid investment strategy. In short, they don’t know how to navigate the pitfalls of the market. One of the reasons we recommend option trading – more specifically, selling covered calls – is because it reduces risk.
It’s possible to profit whether stocks are going up, down or sideways, and you have the flexibility to cut losses, protect your capital and control your stock without a huge cash investment.
But new investors still need to proceed with caution. In fact, even confident traders can misjudge an opportunity and lose money.
That’s why we’ve assembled a list of the 5 most common errors in option trading. If you can avoid these mistakes, you stand a much better chance of success.
Don’t miss: Tips for Success Your First Year Option Trading
Mistake #1: Selling at the Wrong Strike Price or Expiration
When it comes to option trading, strategy is everything. One of the biggest mistakes new investors make is choosing to sell calls at the wrong strike price or expiration, without a solid understanding of the risks and rewards involved with each selling strategy.
When it comes to option trading, strategy is everything.
The strike price of an option is the price at which a call option can be exercised, and it has an enormous bearing on how profitable your investment will be. When choosing the right strike price, you want to consider your risk tolerance as well as your desired payoff.
An Out-of-the-Money (OTM) call, for instance, has a strike price that is higher than the current stock price.
For example, if an investor buys 100 shares of stock for $50 a share, and sells a call option with a strike price of $50, they could collect a premium of $2 per share ($200). Assuming the investor has paid $5,000 to purchase the stock, and they received $200 to write the call option, the total cost per share would be $48 ($50-$2.)
If the stock fell to $48 a share, the option expires worthless and he or she still keeps the $200 premium. But if the stock rises above the strike price of $50 at the time it expires, the stock could be “called away” from the investor. You sell your shares at $50 and still keep your option premium of $200.
An In-the-Money (ITM) option has a strike price less than the current market price. By selling an ITM option, you will collect more premium but also increase your chances of being called away.
When trading options, you also need to pick an expiration. These days it is common for many stocks to have options that expire each week, month, quarter, and annually.
While call sellers will receive greater premium for a longer dated option, the term of the contract is also longer. Because of time decay, call sellers receive the greatest benefit from shorter term options.
Mistake #2: Selling Naked Instead of Covered
When it comes to selling covered calls, the premium is the maximum profit you can receive (in our above example, $200 was the premium and highest potential payout).
If the underlying asset increases significantly in price, the investor may face large losses if they don’t own the shares. This is why most option writers have a position in the underlying asset as well, meaning that they also own the stock and are not just writing options on a stock they don’t own.
Owning the stock you are writing an option on is called writing a covered call. If you don’t own the stock or underlying security, it is called writing a naked call.
A naked call strategy is inherently risky, as there is limited upside potential and a nearly unlimited downside potential should the trade go against you.
Investors may even be forced to purchase shares on the asset prior to expiration if the margin thresholds are breached. Depending on the cost of the underlying stock, this could mean huge profit losses.
As a result of the risk involved, new investors should focus on selling covered calls on stocks they either already own, or wouldn’t mind owning (and have the capital to purchase).
Mistake #3: Forgetting About Dividends
When it comes to evaluating option prices, you want to make sure you take dividends into account before selecting the right stock.
If you purchased 100 shares, you would receive dividend payments if the ex-date is between the time of purchase and expiration, in addition to any premium you might receive by selling a call.
Dividend payments prior to expiration will impact the call premium. Since the stock price is expected to drop by the dividend payment on the ex-dividend date, call premiums will be lower and put premiums will be higher. Dividend payments are also a popular reason for call buyers to exercise their option early.
According to The Motley Fool reinvested dividends make up 42% of large-cap stock returns, 36% of mid-cap returns, and 31% of small-cap returns. Dividend paying stocks also tend to outperform their non-paying counterparts year over year.
This is why it’s important to take the dividends of a stock into account when selecting an underlying security for your option trade. You can also reinvest your dividends later on if more capital is needed.
Mistake #4: Not Having a Plan to Manage Loss
Another common mistake new investors make is not being prepared for a trade to move against you.
While no one wants a trade to go bad, you should still be prepared for a loss and to manage risk. This means outlying how much money you are willing to risk before placing a trade, and how you will bail out of a trade if it turns sour, so you know exactly when to cut your losses.
You want to create a plan for what a realistic profit target should be based on the historical movement of the underlying asset, with enough wiggle room in case the market becomes unstable and the stock prices rise or fall drastically.
Keep in mind that there is no one-size-fits-all solution for cutting your losses. Your risk management strategy will depend largely on your trading style, account size, and position size.
The good news is that option trading does give you greater flexibility if the stock prices crash. You always have the option to buy back the call and remove the obligation to deliver the stock, for instance.
Just remember that if the trade starts moving against you, your first instinct shouldn’t be to throw money at it to get it back even. You want to stick to your strategy as much as possible (even if it’s an exit strategy), accepting some loss if necessary. Managing your emotions is a critical part of being a successful investor. To learn more, take our free course.
Not every trade will be profitable, but you can minimize risk by having a solid strategy before you begin investing.
Mistake #5: Expecting Immediate Returns
Finally, option traders should be prepared to invest for the long haul and not expect immediate returns. While option trading can be profitable, nothing is guaranteed and it is in no way, shape or form a “get rich quick” strategy.
It will still take some time to see the returns you want. A realistic goal would be to aim for around 10-12% return on your investments per year.
Again, it’s important to have a plan in case those returns are lower than expected, but for the most part, your strategy should be for consistent returns over several years, not months.
Here are more tips for success if you’re new to selling covered calls
Final Thoughts
Selling covered calls can be a great way to generate income, if you know how to avoid the most common mistakes made by new investors.
This includes:
- Choosing the right strike price and expiration
- Making sure your calls are covered (that you own the underlying securities if possible)
- Choosing stocks that also pay dividends
- Having a plan should you incur any loss
- Planning for the long-term and not expecting quick results
If you can avoid these common mistakes, you are much more likely to see success with your investments and create sustainable income from your portfolio.