A Common Mistake In Stock Options Trading
Many traders trade stock options because of public opinion, not because the trade itself makes sense. When a particular market trend seems popular, many investors rush in so they don’t feel they’ve missed an opportunity.
The result is that many investors will buy at a price point where the stock options can’t possibly work out favorably. Avoid the emotion of what’s “hot.” Successful stock options trading requires you to notice when emotion affects stock options trading, and create plans to take advantage of the emotional trades of others.
Here’s an example of what not to do in stock options trading: Let’s say you’ve been following a particular stock that is in a “hot” sector, and it just announced a stock split. The stock options are now at 18, and you calculate it could get to 25 or more by the time of the split. The market is currently bullish, and it looks like a great stock options trade.
The problem is that the stock options have been rising for the past four days. They started at 12, but you didn’t notice it until it hit 18 — a 50 percent increase — and They’re still rising. The stock options split is a month away, and you know it’s likely to fall in price somewhat between now and the split.
Still, everyone is talking about these stock options, and what if it just continues to rise and becomes the next blockbuster stock options? You’re afraid if you don’t make a trade you’ll miss a great opportunity. (And besides, you want to be able to tell people that you hold a position in these stock options, because it makes you seem smart.)
So you buy 1,000 shares at $18.50. During the next two weeks, the stock options goes to 19, then levels off, loses momentum, and drifts down to 17. Then a couple of leading NASDAQ companies give earnings warnings, the market drops, and the stock options slides to 15, triggering the stop you’d set at 16 on half your holdings.
The stock options trades in that range for a week, and then begins to rise slightly going into the split. Your plan is to sell a day or two after the split. The stock options rises a little beyond $20.50 by the second day after the split, and then the volume dries up and you sell it for a $2 profit. But since you stopped out of half your shares at 16, you lost $2.50 per share on that half, with a net loss of .50 on 500 shares.
What went wrong was that you didn’t let the stock options come to you. Instead, you chased it as its price rose, knowing perfectly well that — following the stock options split trend — it would probably pull back before running up again.
You knew that it was more likely to pull back than it was to continue on an uninterrupted run to 25, and you knew that if you bought at 18 or higher you were probably paying too much. You disregarded what you knew was more probable in favor of what might happen — even if there was only a very small chance of that unlikely thing happening.
You should have given the stock options a chance to come to you, at a price you felt was reasonable. If the stock options had pulled a surprise and never gotten down to where you thought it would, that would be okay — there were many other stock options to trade, and some of them would have come down to your price. You didn’t have to own this particular stock.
