Many traders make the mistake of purchasing cheap options without fully understanding the risks. A cheap option is one where 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 where the option is trading at a low price relative to its fundamentals. It is undervalued, rather than merely cheap. Investing in cheap options is not the same as investing in cheap stocks. The former tend to carry more risk.
Since options are far more volatile than stocks, following strict rules is an essential part of risk management.
As Gordon Gecko famously said, “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 good investments. The initial cost is generally lower, which makes potential profits bigger if the option is fulfilled. However, it pays to be aware of these seven common mistakes before trading in cheap options.
1. Not Understanding Volatility
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.
High implied volatility usually signifies a bearish market. When there is fear in the marketplace, perceived risks sometimes drive prices higher. That correlates with an expensive option. Low implied volatility often implies a bullish market.
Historical volatility, which can be plotted on a chart, should also be studied carefully to make a comparison with current implied volatility.
2. Ignoring the Odds and Probabilities
Han Solo said, "Never tell me the odds," but smugglers don't know very much about options trading. The market will not always perform according to the trends displayed by the history of the underlying stock. Some traders believe that buying cheap options helps alleviate losses by leveraging capital. However, this sort of protection can 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 merely describing the likelihood that an event 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 the underlying stock's potential. The value of an out-of-the-money options contract depends greatly on its expiration date.
3. Selecting the Wrong Time Frame
An option with a longer time frame will cost more than one with a shorter time frame. After all, there is more time available for the stock to move in the anticipated direction. Longer-dated options are also less vulnerable to time decay. Unfortunately, the lure of a cheap front-month contract can be irresistible. At the same time, it can be disastrous if the movement of the shares does not accommodate the expectation for the option purchased. It is also psychologically difficult for some options traders to handle stock movements over longer timeframes. As stocks go through a typical series of ups and downs, the value of options will change dramatically.
4. Neglecting Sentiment Analysis
Observing short interest, analyst ratings, and put activity is a definite step in the right direction. The great speculator Jesse Livermore noted that "The stock market is never obvious. It is designed to fool most of the people, most of the time." That seems dispiriting, but it does open up some possibilities for traders. When sentiment gets too strong on one side or another, large profits can be made by betting against the herd. Contrarian indicators, such as the put/call ratio, can help traders get an edge.
5. Relying on Guesswork
Whether the stock goes up, down, or sideways, ignoring fundamental and technical analysis is a big error when purchasing options. Easy profits have usually been accounted for by the market. Therefore, it is necessary to use technical indicators and analyze the underlying stock to improve timing.
There is actually a much better argument for market timing in the options market than the stock market. According to the efficient market hypothesis, it is impossible to make accurate predictions about where stocks are headed. Yet, the Black Scholes option pricing model gives very different prices for similar options based on current volatility. If the efficient market hypothesis is correct, options buyers with longer time horizons should be able to improve performance by waiting for lower volatility.
6. Overlooking Intrinsic Value and Extrinsic Value
Extrinsic value, rather than intrinsic value, is often the main determinant of the cost of a cheap options contract. As the expiration of the option approaches, the extrinsic value will diminish and eventually reach zero. Most options expire worthless. The best way to avoid this awful fate is to buy options that start with intrinsic value. Such options are rarely cheap.
7. Not Using Stop-Loss Orders
Many traders of cheap options forgo the protection provided by simple stop-loss orders. They prefer to hold an option until it comes to fruition or let it go when it reaches zero. There is certainly more danger of being stopped-out early due to the high volatility of options. Those with more discipline might want to use a mental stop or an automatic notification instead. A notification can always be ignored if it was just a blip caused by the occasional lack of liquidity in the options market.
Stop-loss orders for options, mental or actual, must allow for larger losses than stocks to avoid whipsaw. Growth investor William J. O'Neil suggested limiting losses to 20% or 25% when trading options. That is far more than the 10% limit that many stock traders use for stop-loss orders.
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 frequently have the highest risk of a 100% loss. 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 for options trades. Fees are much lower than they once were, so trading costs shouldn't be an issue. Take a look at Investopedia's list of the best options brokers to make sure you don't pay too much for options trades.