[Options ABC] Three Mistakes in Options Trading: Your Must-learn Course

Hello everyone and welcome back to moomoo. I'm options explorer. In today's [Options ABC], we'll be taking a look at three common mistakes for options trading.

While many investors seek to maximize profits, it’s just as important to control risk. Initially known as a risk management tool, options themselves are also assets with high risks. To better manage your risks when trading options, there are "three don't" to consider.

Options traders know that liquidity is the lifeblood of options. Some traders, looking for a bargain, might buy options with poor liquidity, but this isn't always a wise move. Options with low liquidity can be hard to sell, posing a significant risk to their holders. Additionally, low liquidity often leads to large spreads between the buying and selling prices, which could result in buying high and selling low.

So, how do you assess an option's liquidity? You may consider three things: the bid-ask spread, the volume, and open interest.

The bid is the highest price buyers are currently willing to pay, and the ask is the lowest price sellers are willing to accept. Generally, options with higher liquidity have a smaller spread between the bid and ask prices.

It's not hard to understand. High liquidity means there are many buyers and sellers in the market, making it easier to find a trading partner. Therefore, sellers may lower their asking prices to sell quickly, and buyers may raise their bids to secure a purchase, narrowing the price spread.

In contrast, options with low liquidity have fewer buyers and sellers, making it hard to find a trading partner. Sellers might increase their asking prices to maximize profit from limited trading opportunities, while buyers might lower their bids due to lack of competition, leading to a larger price spread.

Volume represents the number of option contracts traded in a specific timeframe (like a day), while open interest is the total number of outstanding contracts at a specific time. Rising open interest usually indicates new money entering the market; decreasing open interest may suggest waning interest in the option.

To better explain options' liquidity, this article uses one of TSLA's options as an example. Remember, this is for illustrative and educational purposes only and is not investment advice.

Looking at TSLA's option chain, an option with a strike price of $220, expiring on Feb 2nd, 2024. This call option has a bid-ask spread of $0.1, a trading volume of 6,851 contracts, and an open interest of 22,238 contracts. In contrast, the call option with a strike price of $217.5 has a bid-ask spread of $0.55, a volume of only 3157, and an open interest of 1261 contracts. From this, it may indicate that the $220 strike price option likely has better liquidity than the $217.5 one.

Options, as high-leverage financial instruments, can amplify both gains and losses. For beginners, it's often safer to engage in small trades rather than putting a large sum into a single option. Small amounts allow for controlled risk and the opportunity to develop a personal trading system through trial and error. Going all-in on options can lead to substantial losses in a short time, making the road to recovery long and uncertain.

Additionally, the value of options is influenced not only by the underlying asset's price but also by time decay, volatility, and other factors. Together with the high leverage, minor market fluctuations can cause significant losses for those heavily invested in options.

Given the high volatility of TSLA stocks, their options prices also see dramatic changes. If you buy TSLA stocks at a high price, there's at least a hope of prices returning to that level. With a heavy investment in TSLA options, while there's a chance of making a big profit overnight, there's a higher risk of losing thousands within an hour, especially considering their volatility and expiration.

A key fear in options trading is having a brave yet reckless heart. Some traders, instead of cutting losses or analyzing the reasons for their options' poor performance, choose to increase their position to average down the cost. Unfortunately, this often leads to money flowing away.

It is easy to ignore the common sense that the larger the loss, the higher the return needed to break even. For instance, a 20% loss requires a 25% gain to break even; a 50% loss needs a 100% gain to recover.

Setting stop-loss limits helps maintain a stable investment strategy by reducing the required return to reach the break-even point. It's crucial to establish an acceptable stop-loss level based on your investing goals, like 10%, 20%, or 30%, and adhere to it strictly.

If you're unable to monitor your options continuously, consider using stop orders or trailing stop orders for assistance.

Risk management in options trading is an essential lifelong lesson for every trader. I encourage all investors to learn more about stop-loss and position management while honing their options trading skills. Sharing practical experiences about risk management in the comments is highly welcome and beneficial for all.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts. Don't forget to follow us to stay up-to-date on all things related to options trading.