I speak to retail traders/investors often. Smart folks. Talented. Still, I find that a large percentage of folks who are perfectly willing to actively manage at least a part of their own wealth are somewhat intimidated by options. I hear things like "I really have to learn options" or "I don't have time to learn options."
And if one has spent a career doing something unrelated, I understand that terms like "iron butterfly" or "iron condor" might seem intimidating, and that to try to use these mildly advanced strategies when you have never heard of them before would seem a little daunting.
That said, there is so much that can be done on a basic to near-basic level that I truly believe almost anyone reading this article could make use of options to either enhance equity market returns or protect them, not to mention the trading of options as an asset class all to themselves. The most common mistake made by retail investors in regards to the options market is the belief that understanding options is either beyond their ability, or too time-consuming. Trust me -- you can do this.
Need To Know
For beginners, every option, either put, which is the right to sell a certain security, or call, which is the right to buy a certain security, has an expiration date and a strike price. For example, a General Motors (GM) April 16th $55 call is the right to buy GM at $55 upon expiration. This right has a price. What's built into that price? The probability of that stock trading above that price by that date based on that stock's volatility, and broader sector or market volatility.
This price is known in the industry as a premium, and a key component of this premium is "time premium." In other words, there is a value beyond intrinsic value associated with how far off the expiration date is. Forgetting for a moment that stock prices move around, this "time premium" only goes down as the expiration date draws near, finally reaching zero upon that expiration.
This is why I have always taught that selling (also known as writing) options is preferable to buying options. All things being equal, I would think that you want to sell, not buy something that progressively loses value.
The number-one rookie mistake in trading options would be misunderstanding the relationship between stocks and options. Beginners need to know that one options contract is equal to 100 shares of stock. That matters a great deal if shares are "called" away, or "put" to an investor. Some traders trade only small lots, and can not afford to have to buy 100 shares of a stock like Tesla (TSLA), which recently was trading at close to $600, all at one time. Until one can trade 100 shares of stock at a time, options trading probably has to wait for now.
The number-two rookie mistake would be regularly buying out-of-the-money calls. Let's go back to GM. The last sale as I write this is close to $53. Now, If I were to go ahead and buy one of those April 16th $55 calls, I would have the right to buy 100 shares of GM at $55 in about six weeks. And I would have to pay roughly $2.50 per share right now for that right.
Now, for a stock that I could have bought for less than $53, I need the share price to go up to $57.51 for me to make a penny. That's time premium for you, and it does not hold its value. My experience is that once in a while, you will benefit this way without having to put up as much money up front, but in the vast majority of these cases, the call options will expire worthless, and you're not out $2.50, you're out $250 because of the 100-to-1 relationship. Got it?
The number-three beginner mistake -- and this goes for trading stocks as well as options -- is not having a plan. Know when you're out of here. Regular readers of mine already know that for equity positions, I always teach having a target price; a pivot point where a stock could stop moving or gain momentum, possibly causing me to act; and a panic point, which is a price where the prudent investor must admit defeat and throw in the towel. Well, placing a pivot might be difficult for options trading, but nobody said you had to hold the position through expiration. Have a target, and have a price where you bail before you're sitting there with all of these worthless options on your book.
'Seasoned' Rookie Mistakes
Number one would probably be getting oneself involved in illiquid options. I teach from experience, friends, and this one hurts. Oh, what (not-so-much) fun it is to try to get out of an options position and suddenly realize that the last sale only looks good because this series has not traded in a long while. The quote has moved even in the last sale has not, and that quote might be two dollars wide. No way are you buying or selling even a single contract without making a nasty dent in your wallet.
Number two, at least for me, would be legging into spreads, which simply means entering into the first half of a spread well ahead of entering the second half. I have found that whenever I have the idea to put on a spread, if I do not get every component of the strategy on the tape in short order, it ends up blowing up in my face.
Think you might save a couple of bucks by getting the back half of a spread on at another time, if you expect a sudden move in the underlying security or the time premium to decay a bit? Not worth it, in my opinion. Either you're in or you're out. Legging into a spread can also leave the trader believing the positions cover more bases than they do if he or she gets busy and forgets to go back and finish what they were doing.
Even market veterans make mistakes. I write naked puts on a fairly regular basis. A naked put is a put option sold (or written) by a trader who does not have an underlying short position in the equity involved. This strategy is risky. It does often pay off, but when it goes wrong, it goes wrong in a big way. Traders must understand their own tolerance for risk, as well as be able to pay for their mistakes when they make them.
When a trader has written out-of-the-money naked puts in an attempt to capture some nice premium, and then the floor falls out of that security, the trader must make the decision to either buy back the naked puts at a terrible loss, or accept delivery of the shares at the now much-higher strike price at expiration. The example I am about to lay out is a true story. It is my own.
This is a chart of Nvidia (NVDA) over the last three months of 2018. I had written naked $185 puts with the shares trading around $200 around an earnings release. As you can see, the shares traded in the $190's ahead of the event, and no higher than $170 the next day. I decided to accept delivery. I am confident in my ability to turn almost any situation into a win, and ultimately I did here as well, but I paid $185 for more shares than I care to mention for a stock that traded in the $130's the next week and the $120's the next month.
What did I do? well, I started selling "covered calls", against the position immediately in order to get working on reducing net basis. I had also taken in a nice premium at the start.
It took me until April 2019 to "break even," and Nvidia, if you have followed me on Real Money has served me very well ever since, but that was not a good holiday season.
Stephen “Sarge” Guilfoyle writes on stocks and the markets each trading day for Real Money, TheStreet’s premium site, including his popular Market Recon column every morning. Guilfoyle is also co-portfolio manager of TheStreet’s Stocks Under $10.
Disclosure: At the time of this article, Guilfoyle was long NVDA equity.