Many traders make the mistake of purchasing cheap options without fully understanding the risks. A cheap option can be defined as “inexpensive” – the absolute price is low – however, the real value is often neglected.
These traders are confusing a cheap option with a low-priced option. A low-priced option is one in which the value of the option is trading at a lower price relative to its fundamentals and is therefore considered undervalued, as is not synonymous with the real value of the underlying stock that is being portrayed.
Investing in cheap options is not the same as investing in cheap stocks. The former tend to carry more risk.
The Greed Factor
As Gordon Gecko famously said in the film "Wall Street," “Greed, for lack of a better word, is good.” Greed can be a great motivator for profit. However, when it comes to cheap options, greed can tempt even experienced traders to take unwise risks. After all, who does not like a large profit with minimal investment?
Out-of-the-money options combined with short expiration times can look like a good investment. The initial cost is generally lower, which makes the possible profits larger if the option is fulfilled. However, before trading in cheap options, beware of these 10 common mistakes.
Top Mistakes When Trading Cheap Options
1. Ignoring or not understanding the parameters of implied volatility versus historical volatility can lead to big losses: Implied volatility is used by options traders to gauge whether an option is expensive or cheap. The future volatility (likely trading range) is shown by using the data points.
A high implied volatility normally signifies a bearish market. When there is fear in the marketplace, perceived risks sometimes drive prices higher. This correlates with an expensive option. A low implied volatility often correlates with a bullish market.
Historical volatility, which can be plotted on a chart, should also be studied closely so as to make a comparison to the current implied volatility measures being calculated.
2. Ignoring the odds and probabilities associated with options trading can be a recipe for loss: The market will not always perform according to the trends displayed by the history of the underlying stock. A belief that leveraging capital, by buying cheap options, helps alleviate a loss due to an expected major move by a stock, can certainly be overrated by traders not adhering to the rules of odds and probabilities. Such an approach, in the end, could cause a major loss.
Odds are simply describing the likelihood that an event will or will not occur. Whereas, probability is a ratio based on the likelihood that an event or an outcome will, or will not, occur.
Investors should remember that cheap options are often cheap for a reason. The option is priced according to the statistical expectation of its underlying stock’s potential. Therefore trading outside this option strike price, which is based around a time frame, requires cautious consideration.
3. Neglecting a cheap option’s delta by ignoring its intrinsic value at expiration time is not a smart move: A delta refers to the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative. If the delta is close to 1.00, a call option would be appropriate. If the delta is closer to negative 1.00, then a put option is the play. It is more opportunistic to select higher-delta options as they are more in line with (have similar behavior with) the underlying stock. This, in turn, means that there is a possibility of quicker gain in value as the stock starts to move.
4. Not selecting appropriate time frames or expiration dates can be a problem: An option with a longer time frame will cost more than one with a shorter time frame – due to the fact that there is more time available allowing for the stock to move in the anticipated direction. The lure of a cheap front-month contract can, at times, be irresistible, but at the same time, it can be disastrous if the movement of the shares does not accommodate the expectation for the option purchased. Another consideration is that it is also difficult for some options traders to psychologically handle the stock movement over a longer period of time – as a stock movement will go through a series of ups and downs, consolidation periods, etc. – causing the value of the option to change accordingly.
5. Sentiment analysis (another overlooked area) helps determine if the current trend of a stock will continue: Observing short interest, analyst ratings and put activity is a definite step in the right direction in being able to better judge a future stock movement.
6. Relying on guesswork in regard to a stock movement can be a mistake: Whether the stock goes up, down or sideways, when purchasing options, ignoring the underlying stock analysis and the technical indicators is a big error of judgment. Easy profits have usually been accounted for by the market; therefore, it is necessary to use technical indicators and analyze the underlying stock, so the timing of the options trade is appropriate to the situation.
7. Another area often overlooked is the extrinsic value and intrinsic value of an option: Extrinsic value, rather than intrinsic value, is the true determinant of the cost of an options contract. As the expiration of the option approaches, the extrinsic value will diminish and eventually reach zero.
8. Commissions can get out-of-hand: Brokers are keen to have clients who wish to buy cheap options – the more cheap options that are bought, the more commission the broker will make.
9. Not using protective stop losses can be detrimental to capital preservation: Many traders of cheap options forego this facility and instead prefer to hold the option until it either comes to fruition or let it go until it reaches zero. Usually, this type of pattern relates to laziness or an acute fear of risk – and with this mindset, the trader really should not be trading options at all, let alone cheap options.
Traders that take this approach are the ones that avoid proactive trading, and instead, allow the market to consistently make their decisions for them by taking them out of the trade at the time of expiration. This pattern of behavior frequently leads to a downward spiral of increasing losses, which the trader may seek to ignore by dodging phone calls and discarding unread statements. All of this clearly equates to a highly detrimental perspective on trading options.
10. Sound strategy is often overlooked by novice options traders: New options traders tend to start trading on the wrong side of the spectrum, due to the lack of knowledge and insight, as they aim for pie-in-the-sky profits without a good comprehension of the realities of trading.
11. Succumbing to the lure of cheap out-of-the-money options is really easy to do: However, what seems cheap isn't always a great deal. While buying out of the money options can be a profitable strategy, the probability of making money should be evaluated against other strategies, such as simply buying the underlying stock, or buying in the money or closer to the money options.
The Bottom Line
Both novice and experienced options traders can make costly mistakes when trading in cheap options. Do not assume that cheap options offer the same value as undervalued or low‑priced options. Of all options, cheap options can have the greatest risk of a 100 percent loss as the cheaper the option, the lower the likelihood is that it will reach expiration in the money. Before taking risks on cheap options, do your research and avoid overpaying where you shouldn't be. To get a head start, take a look at Investopedia's list of the best options brokers so you can have more confidence investing your money.