Whenever I conduct my introductory session in option workshop, I was often asked to comment on other trainers’ strategies and methods. Certainly, it was neither proper nor professional for me to speak of competitors’ training methods and course materials without really having understood what they covered. In my opinion, every trainer has his/her own reasons for trading in certain way depending on the types of risks that he/she is taking. It is really the individual’s responsibilities to understand those risks and to decide whether or not the trading methods suit their own risk profiles.

The option enthusiasts who wish to take the first step into the options market should really think about the risk associated with certain strategies. It is not uncommon for many trainers to market their courses by stating explosive returns in the thousands of percent on their investment in, say, 3 days. It is certainly possible with options. However, the next question becomes the sustainability of that approach of trading. In an article of “How Options Work” on this blog, I mentioned that there were fast way and slow way of trading. In my experience, the slow way is the one that is more sustainable – which is the “write” way.

In any case, any beginner to option must be aware of the following pitfalls, regardless of the methods use. There are countless books written by professional and seasoned traders that support these viewpoints. These are professional consensus and opinions. Let’s see what they are.
 

1. Use Option to Trade as if it is a Stock

Many novice option traders buy options to trade the same way as stocks. Normally, a market movement is expected of a stock. Instead of buying the stock, the traders buy the options to the stock. The reason for doing this is obvious – the leverage inherent with option that gives explosive return. This is fine provided you are aware of these three differences: 

• Unlike stock, options have time values and will depreciate to zero upon expiration. Hence, option is commonly known as a wasting asset. If an option holder (or buyer) keeps the option contract until expiration, he/she may not make money even if the stock moves in his/her favor. Since more than half of the option contracts expired worthless every month, the odd is against the buyers. Buyers can only come out winners when the underlying stock moves quickly in the intended direction. Buyer must also be absolutely certain of the direction of the market movement. This demands solid trading techniques and skills of the traders. Novice traders will generally find it difficult to achieve the intended result on the outset. Hence, I don’t recommend this approach of trading for beginners. The only advantage to this approach is the ease of understanding and execution.                                                                                                                                                                    
• Liquidity is a major issue with all options. Not all options are liquid even if the underlying stock is heavily traded. Options that are deep in-the-money or deep out-of-the-money will have severe liquidity problem. Hence, if a trader makes money when it is in the money, he/she will find the return lower than expected because the trader will suffer time value decay plus big slippage. Slippage is the difference between the intended price to buy or to sell an asset and the actual price that is transacted. Illiquid options will have big slippage problem.
   
• Of all the three issues, this is the major one. Since nobody can be absolutely certain that the market moves away from the entry price without a pullback, it is easy for option trader to get stopped out at stop-loss point and then to see the underlying moves again in the intended direction. This is very, very common with a mechanical trading system. Option buyers must have a very good money management system to protect themselves. Stop-loss trigger is not an effective money management. Trader will normally have a big drawdown on the account before seeing any profit, if any.

Ways to prevent the above problems from haunting you is to know that trading based on mechanical system cannot work most of the time. If you can treat it as a bonus trade that happens rarely and place your trade selectively, you can come out winner.

 

2. Black-Box Option Trading System

Black-box trading system refers to the systematic approach to trading a market with clear entry and exit points. It is called a system because it defined strict rules to follow with no exception. Black box trading systems tells you what to buy and sell and when to buy or sell it without telling you why or giving reason to take a position.

Quoting from renowned U.S. stock trader Dr. Alexander Elder, “each black box is guaranteed to fail.” Thousands of traders had paid good money for it. Black boxes always come with impressive track records showing profitable past performance. However, “every black-box self-destructs because the markets keep changing.” Nothing can replace human interpretation of market because market changes and the black box trading system cannot foretell.

Anyone uses options to trade a black box system will invariably lead to huge losses. It does not take very long for a trader to see his/her entire trading capital wiped clean. Reason is simple: The leverage power of option magnifies the losses.

The way to avoid such trading system is not to buy one. If you have to, always make sure you ask the rationale for trading market the way it suggested. Don’t get taken in by the past results. Past performance is not an indication of future profit.      

 

3. Scanning for the Best Trades

Certain traders scan the entire U.S. market for trading signals to take position. This is a dangerous endeavor. There is nothing wrong for scanning the market for signals. However, a trader needs to understand the underlying past behaviors and liquidity, and probably the fundamentals as well.

Most option traders failed to understand the underlying instrument but trade it when a signal is obtained through scanning. Initially, everything seems alright until after a position is taken. The most notable change in the underlying instrument is its volume, including option trading volume. A stock, for example, can have unusual movement with high volume. For some reasons, the excitement toward the stock subsides. Volume falls. Even if the stock moves sufficiently to make a profit, the trader cannot exit because suddenly there is no taker of your option or he/she have to take severe slippage just to get out. The profit cannot be realized.

Successful professional traders often stick to only a few highly liquid stocks or futures markets for most of their trading life. They may not be bothered with scanning for chart signals. However, they do scan for clues, such as volatility, of a market which gives them a trading edge.      

 

4. Trading Methods that Ignore Volatility

There are times that we should buy options and others sell them. Although it is not a guaranteed technique, buying strategy will work with higher probability of success when the option volatility is low. On the other hand, selling strategy works more effectively in time when volatility is high. Traders who ignore the volatility of the option will make less money, if any, in the long run. Mechanical trading systems generally ignore volatility.

During period of high volatility, time value is high. Buying option with too much time value will have great time value decay. Time value collapses quickly especially within the last 30 days of the option validity period. Buying option when the volatility is low will have tremendous boost to the return on investment because time value will expand which contributed to the option value. Therefore, the ability to understand the period in which one should buy or sell an option will give the trader a definitive edge.

Volatility based trading is a great way to achieve consistent profit. Many renowned, successful option traders are volatility based traders. To trade option volatility, one requires more study in this subject. Find a good option course that teaches volatility to equip yourself with better trading arsenal.      

 

5. Ultra High-Return Strategies

Options trading can deliver ultra high-return trade result that fellow stock traders can only dream. Returns with 10% to 200% are quite common with certain trade methods. In fact, there are trades that can yield more than 100 times of the initial investment. Nevertheless, there is inherent problem with those trading systems that give those explosive returns. Most of the problems are related to the trading systems themselves, not the options.

One must understand that no trading system is foolproof. The stock and futures markets are ever changing. No single trading system can interpret the dynamics of mass behaviors successfully without some human judgment. This is because we are trading against other traders whose minds are always changing. There is no sure way to know how to get in and get out. We can only look at the probability. Money management is the next level of protection for trader with trading system. However, novice traders are generally not good in money management as they are very much taken in by the attractive returns of this kind of trading systems.

The key to propelling a beginner to continue his/her interest in options is confidence! Until the trader makes money in a series of trades, he/she is bound to lose confidence and interest in options. Trading system failed to build confidence because the severe losses resulting from the leverage power of option when the trader is wrong are serious confidence killer. Leverage power of option cuts both ways. It can either deliver high returns or severe losses. A trading method that delivers small, but consistent result is more suited for the beginners.

 

Finally, in selecting the right trading strategies for oneself, he/she must know his/her risk profile and trading styles – fast or slow. However, building confidence in a trading method should be the first priority when trading it the first time. Confidence is a result of achieving a series of winning trades. Therefore, it makes sense to stick with strategies that are stable and consistent in generating profit, never mind the rate of returns. Confidence can also be built by continuous learning through more reading and practicing. Further study by attending higher level seminar can also do the trick. Every effort you make will contribute to your own trading success.

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