How Do You Lose Money in Options?
Options buyers lose money because they do not understand the risk they are taking and tend to treat the options market in the exact same way they would when trading stocks and futures.
Options trading is simply the act of buying and selling options. These contracts are linked to an underlying asset such as a stock. This gives the buyer the right, but not the obligation, to buy or sell the asset for a specific price before a certain date.
One of the main uses of options trading is to generate extra income and hedge risk. For example, using options to hedge against a declining stock market can effectively limit the downside losses. Often, options are also used for speculative purposes, such as wagering in the direction of a stock.
As with other financial instruments, also with options, there are risks that investors must be aware of and take into account when trading. In general, more than 80% of options expire, making them worthless, meaning the options buyers lose money, while the options sellers make money on the other side of the trade.
In this article I will explain the top 9 reasons why options buyers lose money.
Top Reasons Why Option Buyers Lose Money
Here I will explain to you some of the main reasons option buyers lose out on money, so you can avoid making the same mistakes.
#1 – Treating Options Like Stocks
One of the main reasons option buyers lose out on money is that they treat options like stocks. However, options, contrary to stocks, are a depreciating asset with an expiration date. You can’t hold an option forever like you could do with stock in a company.
Every day, an option contract loses a portion of its value (called time value) until it expires completely on the expiration date. Understanding this crucial difference is the first step to avoiding losing money when trading options.
#2 – Buying OTM Options
The option premium is the sum of the intrinsic value of the contract alongside the time value of the options. Out-of-the-money (OTM) refers to an option that has no intrinsic value but only extrinsic value.
New traders in particular think that buying OTM options is a good starting place. They tend to buy OTM options as the premium is very low. However, the premium is low because the probability of reaching a profitable level is also low.
In a way, out-of-the-money options are the equivalent of penny stocks in regular stock trading. It may feel like a safe option, but it is one of the hardest ways to make money consistently in options trading.
If you’re buying ATM options or ITM options, you usually pay a higher premium compared to OTM options, but the probability of the option expiring ITM is also higher.
As with OTM options, the entire value of the option is time value, time is sensitive and works against you (and in favor of the options sellers on the other side of the trade). This is one of the main reasons options traders lose money. If the underlying stock doesn’t see a quick and dramatic increase in the trader’s favor, the contracts will therefore expire worthless and you will lose the amount paid as a premium.
#3 – Holding Options Too Close To Expiration
When traders try to hold the option too close to the expiry date, they tend to lose money. The loss of time value starts to decrease even more rapidly when the expiry date of the option is approaching.
Generally speaking, an option loses one-third of its time value in the first half of its life and the remaining during the second half of its life. That, of course, can vary depending on the whole duration of the option contract, but it gives you an idea of how the time decay (losing value as time passes) of an option tends to accelerate the closer you get to expiration.
If you’re getting a good price, it’s more beneficial to exit at a profit when there’s still some time value left. Time value is a wasting (or decaying) asset as the value converges towards zero the closer to the expiry date it gets. Leaving the option to expire means you’ve allowed it to become worthless.
#4 – Holding Options Ahead Of Key Events
This is due to a phenomenon called implied volatility (IV) crush. In principle, before an important event such as the quarterly earnings announcement of a company, options tend to get more expansive due to the uncertainty of the event’s outcome. However, once the event has passed, the outcome is then clear to everybody, and as a consequence, the price of the option rapidly gets much cheaper.
For this reason, if traders are holding their options ahead of key events, they can lose money on long options. Predicting whether a stock is going to do well in the market or fall in price following an event is nothing more than a bet. What is certain is that its option price will fall dramatically as a result of the implied volatility crush.
#5 – Bad Risk Management
A proper risk management plan can help traders cut down on losses and stop them from losing all their money. Leverage is the other side of the risk management coin, and it is also crucially important when it comes to your trading account protection.
You can use the power of leverage when trading options by determining the appropriate amount of money to put at risk. Running a series of “what if” scenarios can help you keep the total risk in balance, using your risk tolerance as a guide.
As a general guideline, you shouldn’t be buying options for more than a small percentage (less than 5%) of your capital at a time.
#6 – Averaging Down Losing Positions
Averaging down on losing positions adds considerable risk and is normally something to avoid. As options are time-sensitive, you will always have the passage of time (something that nobody can stop) working against you.
The correct way to trade is to never get overexposed to any trade. You never want to lose more than a small percentage of your trading capital when an option you bought expires worthless.
#7 – Not Using Stop Losses
There will always be losses when you are trading, and they are easier to accept when they are small. When losses start to expand, having a stop loss in place is important. Accepting small losses and moving on is vital for the longevity and prosperity of your trading account.
When buying options, there is a constant depreciation of the premium, and every extra day that you’re holding on, the positions significantly lose time value.
Stop losses are an important risk protection tool and can make a big difference in terms of long-term trading success.
#8 – Not Buying And Selling At The Right Time
Stock and options markets can be more or less volatile depending on a number of reasons such as news, economic trends, political events, companies’ earnings results, etc. Volatility causes stocks or indexes to swing either way quickly and substantially.
When markets and stocks are volatile, options become more valuable and vice versa. A negative of this is that options premiums are more expensive, but on the positive side, your returns can be unlimited.
Be sure to always look at the volatility of options rather than just the price aspect, as this is a common mistake beginner traders make.
#9 – Buying Underpriced or Overpriced Options
Similarly to a stock or asset, an option can be underpriced or overpriced due to factors such as time, risk, or volatility. There are ways to tell if the option is underpriced or overpriced, such as the Black & Scholes formula. It was created in 1973 and is still recognized as one of the best methods for pricing an option contract.
This formula calculates whether the option you are buying is either underpriced or overpriced. The formula and calculator can be found on trading terminals and through online searches.
Checking this formula can be useful to reveal information about the fair valuation of an option contract. Using it when buying or selling options can majorly reduce the risk of options trading, which is something every trader wants.
Final Remarks
Trading in any market is a risk, but there are some common mistakes that option traders make that cause them to lose money. Here I have listed some of these common mistakes so that you can learn to avoid them and improve your trading skills.
I hope you found this article interesting and informative. You can always save this for later if you need to remind yourself of how to avoid losing money in options trading.