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Many beginning investors focus on what they need to do to find success. And that is perfectly normal. After all, you need to select the right stock, the right option, and then buy it at the right price.
But knowing when to sell is only half the formula. There are also important things to avoid in this process.
Today, we're going to talk about the six biggest options trading mistakes you could make starting out.
Perhaps you were making some nice money during the rally off the March low. Nothing wrong with that. However, the problem is that a bull market tends to hide flaws in anyone's methodology.
That means the market could turn back down, and you start having a few bad days without knowing why. After a few losses, you begin wondering what is going wrong.
Experts can help you here. Knowing what not to do, or simply doing nothing, can be as worthwhile as being able to pick a stock.
Money Morning's options trading specialist, Tom Gentile, has taken his years of experience and distilled that down into easy bites. His list of six of the biggest options trading "don'ts" should be pasted up on the side of everyone's trading screens.
Here are some options trading mistakes that can be avoided if you stay on top of them.
Options Trade Mistakes
Most individual investors and traders know that they need to have a plan, manage risk, and put in the work learning and practicing. If they do that, they are well on their way to profits.
But the six "don'ts" will help keep you out of trouble. Let's begin…
Don't place market orders – A market order tells your broker to execute your buy or sell order as soon as possible and at the current bid or ask price. That's a fine strategy for liquid stocks where the bid-ask spread is highly competitive and you are likely to get the best price. However, most options are far less active and have fewer players wanting to buy and sell. Remember, there are dozens of options on most stocks and many of them are very far from the money. That means they are unlikely to garner much trading interest.
Instead, use limit orders, which set the maximum price you are willing to pay to buy, or the minimum price you are willing to accept to sell.
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Don't chase a trade – Sometimes you will not be able to buy your option at your desired price. When this happens, do not keep raising your limit price. If you do, you may end up buying that option at too high of a price for the expected result or target price to be profitable. There will always be other trades coming your way, so stick to your plan. Do not get caught up in a market that is getting out of hand.
Don't over-trade – This is money management. While adding to a winning position is often warranted, you should never add more than you can afford. And by "afford," we mean as a percentage of your trading portfolio. If you do, then you risk blowing up your account on one trade, should it start to move against you. As with the previous "don't," there will be other trades. You don't have to put all your trading eggs in one basket.
There is one more part to not over-trading. Never think that you can make up for a losing streak with one big score. That's how gamblers get into trouble. If you even find yourself with a string of losers, stop trading. Take a breath. Think about what might have been the problem. After all that, you can consider making your next trade.
Don't wait until the last minute to make your trade – Strange things can happen at the end of a day. Especially at options expiration. Liquidity can easily dry up, and that means you may not be able to get a price anywhere close to what you were expecting. In addition, the time decay factor embedded in an option can cause its value to crater at the last minute.
One way to avoid this without worry is setting a "good-til-canceled" limit price based on your profit target, rather than trying to time it near expiration. In other words, sell when price reaches your target, no matter when that happens before expiration.
Don't trade without a plan – This is exactly the same as the "do" mentioned earlier. You've got to know your trading goals, expected profit and allowable risk. And you have to know what will have to happen to make you cut your trade short before a small loss turns into a big loss.
Don't bet the farm – We've already discussed this in a few ways, but it is that important. Do not take such big risks that one losing trade will drain your account. And never think that you can make up for a string of losers with that one big win. Keep your position size between 2% and 5% of your portfolio. If the market gets exceptionally volatile, make that even smaller. You want to be sure you live to trade again tomorrow.
These are simple rules to keep your ego in check because the market owes you nothing. Respect it, and you will do just fine.
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