October 7, 2022

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Unique ways to prevent overtrading options

Are You Overtrading? Here's How to Stop - Daily Price Action

Overtrading options is an issue that affects many traders. For those who do not know, overtrading involves buying or selling an option contract multiple times in the hopes of quickly earning money. It leads to financial loss because options are meant to be traded once; they are not created for short-term investors.

Overtrading destroys your capital just as it snuffs out your chances of becoming a successful trader. How can you avoid this pitfall?

Don’t trade options if you can’t afford to lose

It may be apparent, but it needs to be stated. If you don’t have a sizable bankroll and risk tolerance, trading options will hurt you probably more than any other trading strategy. It’s easy to overtrade options when the stakes are higher because they move quickly.

Watch your position size

Allocating 1% of your capital for each option contract that trades is a good rule-of-thumb for those who want to avoid overtrading. In essence, this means placing a sell order for one option contract for every $100 in the capital you have available/want to risk on options contracts. This general calculation creates a conservative approach that helps prevent overtrading.

Never create a ‘short strangle’ position for option trading

This position relies on the stock going up or down as much as possible to make money. That is to say; you are betting that the underlying security price will go up and decrease at some point in time. Your risk is unlimited if this occurs because your loss is theoretically infinite since you have an open short position with no stop-loss order to close it out automatically.

Enter a stop-loss order when placing a sell option order

While not perfect, you can use a stop-loss order to prevent overtrading options by designating a limit price that triggers termination of an open option contract to recoup some of your losses before they get worse. A stop-loss order should be very close to the current market price but never lower than that price.

Move your stop-loss order higher for higher percentage gains

For example, if you place an options trade with a bullish view on XYZ stock at $50 per share, move the stop-loss order up by $2 for each succeeding increase in option value of $1. For instance, if you have a limit sell order placed at three contracts when the options are trading near $3.00 per share, set it to 6 contracts when it reaches $6 per share and so on until you reach the predetermined maximum allowable percentage gain that you are willing to risk.

Know the time of day when using stop-losses

Typically, option prices are higher at 8 am-11 am EST than between 11 am-2 pm EST due to increased demand. Placing a stop-loss order during this window can cause you to accept more significant losses. For example, if XYZ stock goes up from $50 per share to $57 within 5 minutes of market opening, then drops sharply back down below your stop-loss limit before 2 pm, your trade will be automatically closed with an unlimited loss. This is because it is below the specified dollar amount you have set the order limit.

Treat options as stocks on days that they move very little

The value of an option daily fluctuates because it depends on how much the underlying security moved. When the stock moves up or down only marginally, options will trade at parity with their underlying stock price, resulting in limited P/L. As a result, if you are buying put options when the P/L is minimal, be sure to adjust your stop-loss order accordingly. If XYZ is trading at $50 per share and you buy yielding 2% return opportunities, set your stop-loss limit price to reflect this by moving it higher every time you make another 1%.

Avoid ‘all or none’ orders for option contracts

These orders give brokerages complete discretion regarding what they decide is best for your account, which can be dangerous for new option traders. Just like stop-loss orders, not all brokerages will limit their activity, so they can trigger an order to close out options contracts at a price of their choosing.

Now that you know how to avoid overtrading options, why not try it with Saxo?