Friday, August 12, 2005

Costly Mistakes

I've learnt my options trading mistakes through the hard way by losing money with them, I hope you could avoid them by learning from mine.

Mistake #1 - Trading options like a stock

Yes, the underlying asset of the options I trade are stocks, but that doesn't mean I should trade options like I would trade stocks. As I've earlier mentioned, options are depreciating assets. This means that if an event which you anticipate did not happen within the contract period of your stock option, you would have to sell your option quickly hopefully at a small loss (since the time value portion would have depreciated substantially) or you would stand to loss the entire money paid for the option premium if you simply let the option expire worthless.

I've read books written by stock market "gurus" which advocate buying a stock after it has broken its resistance line and sell a stock when it has broken its support line. The mistake I made was that I've bought the stock option & thought that the stock would move quickly in my anticipated direction. Sometimes when a stock breaks out from its resistance or support line, it might consolidate for a while before it moves further in the trend it established. So, if you hang on to the option hoping it will move up (if resistance line is broken) or move down (if support line is broken) but it didn't happen before the expiration month of your option, you are going to see your option contract lose money quickly because of the effect of decaying time value.

The way to make money from this solution is : If you see volume building up (from the stock chart) and the stock is about to break out from its resistance or support line, buy at least a 2-months out option before the resistance or support line is broken and IMMEDIATELY sell the option the moment the breakout occur. One thing about option is that once an anticipated event has occurred (in the case breaking out from its resistance or support line), the option would still lose value because its implied volatility has also erode. So, sell the option quickly, hopefully for a profit, when the breakout occurs.

Tony Chai


option education said...

Well done on a nice blog Blogger. I was searching for information on stock option trading and came across your post Costly Mistakes - not quite what I was looking for related to stock option trading but very interesting all the same!

Well, Christmas is over and we're all getting ready for the new years and there aren't many trading days left. Although I'm still trying to grapple with where the dollar's headed next year. My feeling is that it's going to be much the same as this - all over the place, but possibly on the ascendant over the year, mainly due the instability in the Eurozone. And as for stocks, I think the safest thing is to stick to trading the indices. There's still too much downward pressure.

If you do have a moment, please take a look at my new site on: Option Trading .

A merry Christmas to you and yours! Amon