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Stock options are complex, so it’s important to proceed with caution if you want to start trading options. The reason? It’s possible to lose far more than you even invested, and in a short period of time. In this post, you will learn about what stock options are, the different types of stock options that you can buy, and four common mistakes to avoid.
What Are Stock Options?
A stock option is a contract that gives an investor the right, although not the obligation, to buy or sell stock at a predetermined price by a specific date. There are two different types of options: calls and puts. A call option gives the investor the right to buy at a set price, while the put gives them the right to sell at the predetermined price.
4 Common Mistakes When Trading Stock Options
1. Strategy Doesn’t Match Your Outlook
When you’re trading options, you need to develop an outlook for what you think could happen. This requires you to use fundamental analysis, technical analysis, or both.
Fundamental analysis involves evaluating a company’s performance data, financial statements, and trends in business, while a technical analysis involves interpreting volume and price on a chart. The outlook that you develop should not only consist of determining which direction the stock will go, but also include a time frame for how long you think it will take.
2. Putting Too Much Money Into One Trade
Stock options should be used to give you leverage. They are not meant to be a long-term investment. That’s why it’s important never to risk more than you’re comfortable losing if the stock went in a different direction than you’re expecting.
3. Picking the Wrong Expiration Date
As mentioned above, stock options have an expiration date by which you are required to buy or sell. If you don’t exercise that option, you will lose it. If you have developed an outlook using a thoughtful analysis of the market or company, then selecting the expiration date should be relatively straightforward. Some important considerations are:
— Length of time it will take for the trade to play out.
— Whether you want to hold it through a specific event like an earnings announcement.
— Whether there is enough liquidity to support the trade.
4. Failing to Consider Upcoming Events
While it’s not always possible to anticipate major events that can impact the stock market, there are two important events that you should always keep track of: dividends and earnings dates for your underlying stocks.
For example, if there’s a dividend approaching and you’ve sold calls, there is an increased likelihood that it could be assigned early if the option is in the money already. You, as the option owner, have no rights to the dividend, but to collect, the trader has to exercise their option to buy that stock.
These are just a few of the most common mistakes that investors make when trading options. The most crucial step to remember is that you should develop a plan for trading and stick with it. Also, take time to learn about different options strategies and some of the common options trading mistakes to make more successful trades in the future.