Many traders make the mistake of purchasing options that are cheap in price without fully understanding the risks involved. It is important to note that a cheap option does not necessarily mean that it is undervalued.
In fact, the real value of an option may be neglected when its price is low. It is crucial to distinguish between a cheap option and a low-priced option. A low-priced option is undervalued and trading at a low price relative to its fundamentals.
On the other hand, a cheap option is simply one where the absolute price is low, but this does not necessarily mean it is undervalued. It is essential to understand that investing in cheap options is not the same as investing in cheap stocks. The cheap options tend to carry more risk than undervalued options or stocks. Therefore, it is important to thoroughly research and analyse an option’s fundamentals before investing in it.
Experienced traders may take unwise risks due to the temptation of cheap options and the desire for large profits with minimal investment.
When investing, it may seem like a good idea to buy out-of-the-money options with short expiration times, as the initial cost is typically lower and the potential profits can be larger if the option is fulfilled. However, before trading in these cheap options, it is important to be aware of seven common mistakes that investors often make.
Lack Of Comprehension Regarding Volatility
Options traders use implied volatility to determine whether an option is expensive or cheap. Implied volatility represents the future volatility and likely trading range of the option.
High implied volatility indicates a bearish market, where fear drives perceived risks and prices. This usually means an expensive option. Conversely, low implied volatility implies a bullish market.
To make a comparison with current implied volatility, it’s important to study historical volatility, which can be plotted on a chart.
Disregarding Odds & Probabilities
Han Solo once famously said, “Never tell me the odds,” but when it comes to options trading, relying solely on chance is not a wise strategy. The stock market is unpredictable, and past trends might not accurately predict future performance. Some traders may think that buying cheap options can help mitigate losses by using leverage, but this type of protection can be overrated if the trader does not follow the rules of odds and probabilities. An impractical approach could ultimately result in significant losses. The odds merely indicate how likely an event is to occur.
Investors should keep in mind that options that are inexpensive are sometimes priced that way for a reason. The option’s price is based on the statistical outlook of the underlying stock’s potential. The value of an out-of-the-money options contract is heavily influenced by its expiration date.
Choosing Inappropriate Time Frame
When it comes to options trading, it’s important to keep in mind that an option with a longer time frame will cost more compared to one with a shorter time frame. This is because there is more time available for the stock to move in the anticipated direction. Longer-dated options are also less susceptible to time decay, which can be beneficial.
However, the temptation to go for a cheap front-month contract can be strong, but it can prove to be disastrous if the movement of the shares does not align with the expectation for the option purchased. Additionally, some options traders may find it challenging to handle stock movements over longer time frames. As stocks go through their usual ups and downs, the value of options can change drastically.
Overlooking Sentiment Analysis
Taking into account the short interest, analyst ratings, and put activity is a crucial step toward making informed investment decisions. One of the legendary investors, Jesse Livermore, once said that “the stock market is never obvious. It is designed to deceive most of the people, most of the time.”
Although it may sound discouraging, this reality presents some opportunities for traders. When the market sentiment becomes too one-sided, traders can take advantage of it by going against the herd and making sizable profits. Contrarian indicators, such as the put/call ratio, can provide traders with an advantage.
Dependence On Speculation
It is important to consider both fundamental and technical analysis when buying options, regardless of whether the stock is rising, falling, or staying stagnant. The market has already factored in any easy profits, making it crucial to use technical indicators and analyse the underlying stock to determine the best timing for your purchase.
Interestingly, market timing is more effective in the options market than in the stock market. This is because the efficient market hypothesis suggests that predicting stock movements is impossible. However, the Black Scholes option pricing model provides varying prices for similar options based on current volatility. If the efficient market hypothesis holds true, options buyers with longer time horizons can improve their performance by waiting for lower volatility.
Novice and experienced traders should be cautious when trading cheap options. It’s essential to understand that cheap options don’t always provide the same value as undervalued or low-priced options. In fact, cheap options are the riskiest and can result in a complete loss. As the option gets cheaper, the chances of it expiring in the money decrease.
Before trading cheap options, it’s crucial to conduct thorough research and avoid paying too much for options trades. Trading fees have decreased over time, so you shouldn’t be concerned about trading costs.