Unveiling The Pitfalls: 3 Common Option Trading Faults You Must Avoid

Many new traders stumble into the world of derivatives trading with dollar signs in their eyes, without fully understanding what they’re getting themselves into. Lured in from huge gains they’ve seen on Twitter or the Wallstreetbets subreddit, people try their hand at trading options.

Unfortunately, the breadth of research (a great example is Option Trading and Individual Investor Performance revised in 2015) at our disposal continues to highlight how ineffectual this haphazard approach is. Let’s dive into some of the common issues traders face with options and how to overcome them.

Options are a financial instrument known as a derivative. This simply means the value and behavior of an option is derived from another underlying asset (such as a stock, ETF, etc.). While most traders enter the market counting what they’re going to do with all the money they intend to make, the reality is dimmer and looks much more like this.

For every success story you see, there are exponentially more failures. Yet, I’ve traded options since 2007, so against this backdrop, why would I do that? The answer is simple - taking the time to understand the common issues and learning to overcome them.

Options Trading Fault 1 - Misunderstanding The Challenge

• Options traders often get off on the wrong foot, in my opinion, because the barrier to entry is SO LOW and extremely misleading. To start trading options, you just need to save some money and open a brokerage account. ​​​​​​This effect is known as skill gap, where something appears to be deceivingly easy but there’s actually a tremendous amount of work required to make it look so (think of surfing, professional athlete, etc).
• To overcome Fault 1 take a weekend and conduct research on the realities of retail traders. Open up SSRN and dive into the world of free peer reviewed research. If we want to climb Mount Everest, we need to study it. See how other successful people have done it. Learn from their mistakes and best practices. The same goes for trading. We need to research what we want to accomplish.

Options Trading Fault 2 - Misunderstanding Edge

• Markets are indifferent. They don’t care how hard you worked. Nor do they care if you tried your best. This is the beauty. You can diligently create an approach and optimize it over time. However, a specific options structure, how hard you work, how well you take notes, all equally are NOT an edge. These are baseline expectations.
• To overcome Fault 2 review your strategies and determine HOW they make money. Is it because you’re good at picking directions? Are you good at predicting volatility? THIS is where your edge lies.

Options Trading Fault 3 - Dunning-Kruger Effect

• Simply put, the Dunning-Kruger Effect is where a person misunderstands their ability or knowledge and overestimates their proficiency. This combined with skill gap (discussed above) creates a tricky situation that catches most traders at one point or another, it certainly captured me.
• I took my largest percentage drawdown suffering from this exact effect. I had been trading options for ~5 years, had a fair understanding and was overconfident in the probabilities. This led to a move that I hadn’t thought through how I’d manage, and ultimately taking the loss to stop the bleeding. All could’ve been prevented had I practiced the strategy more before trading.
• To overcome Fault 3, I use two tools. The first is creating a written trading plan and supporting strategy outlines (to learn more about these, you can check out this video: https://youtu.be/feFqr3W98SM) these force us to think through our approach more thoroughly and we can ramp up the scrutiny by having others review our work and poke holes with the goal of firming our ideas up. Second, is papertrading. While it's an uncommon tool for most traders because it's boring, imperfect, requires work, and will never fully replace real money - it's an unsung hero. Here we are able to practice ideas, test concepts, and create a supporting dataset.

While there are a litany of pitfalls in trading Options, they can be incredibly useful tools. My next article will take the otherside of this discussion and focus on three effective use cases for options traders. Be an Outlier!

Erik is a Marine veteran, stock market trader, real estate and angel investor. He became a first generation millionaire before 30 through saving, investing, and creating more income streams. He began trading in 2007 and has spent over 30,000 hours honing his craft. He primarily trades derivatives and has consistently outperformed the market. You can learn more about him at his webpage: www.esinvests.com or check out his YouTube channel: www.youtube.com/esinvests.

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