Why 90% of Option Traders Are Bleeding Money Before They Start

(don't be this person)

Author

Don Kaufman
October 22, 2024

Don Kaufman here. 

Today, we're diving into a topic that's near and dear to my heart—saving you money before you even place that first trade. 

If you've ever wondered why your seemingly brilliant option trades aren't making the money you expected, stick around. 

We're going to uncover some common pitfalls that might be eating into your profits before you even get in the game.

The Big League of Options Trading

You know, one of the fascinating things about options trading is that there's no minor league. 

Whether you're a newbie or a seasoned pro, we're all playing on the same field. 

It's like jumping straight into the NFL without any college ball experience. 

Exciting? 

Absolutely. 

Intimidating? You bet.

Options have been around since the 1970s, but let's face it—they've only hit the mainstream in the last few years. 

With advancements in trading technology and media coverage, retail investors now have access to tools and platforms that were once reserved for Wall Street elites. 

I saw this develop first-hand, being part of the ground floor at thinkorswim. 

But with great power comes great responsibility—or, in this case, the need for greater knowledge.

The Allure and the Danger of Options

Options are like that flashy sports car—you can go from zero to sixty in seconds, but if you don't know what you're doing, you can crash just as quickly. 

These aren't just another investment vehicle… they're leveraged products that can provide obscene returns in a short period. 

But leverage is a double-edged sword. Without a solid understanding of how options move, you might find yourself losing money faster than you can say "time decay."

That's why I always stress the importance of getting the basics down. 

If you're new to options or even if you've dabbled a bit, make sure you've got a strong foundation. 

And if you’re looking for daily market commentary along with how we at TheoTrade use options, make sure to check out our YouTube Channel. 

The Illusion of Liquidity

Let me paint a picture for you. You have a hot stock tip, or maybe you've done some stellar analysis, and you're confident about where a stock is headed. 

Instead of buying the stock outright, you think, "Hey, why not use options? Less capital, less risk, more leverage." 

Sounds great, right?

Hold on a second.

Just because options have these benefits doesn't mean every option on every stock is worth trading. 

In reality, there are only a couple of hundred options that offer competitive bid/ask spreads. 

That means you've got to be selective—very selective—about which options you trade.

Digging into the Options Montage

First things first: Always start by opening up an options montage for the stock you're interested in. 

It's a fancy term, but it simply refers to a list of all the tradable options for a particular stock, categorized by expiration dates and strike prices. 

Here's what you're looking for:

  • Volume: The number of contracts traded that day.

  • Open Interest: The total number of outstanding contracts that haven't been settled.

  • Bid/Ask Spread: The difference between what buyers are willing to pay and what sellers are asking for.

These metrics give you a snapshot of liquidity. High volume and open interest mean tighter bid/ask spreads, which is crucial for your trading success.

Despite trading at over $140 per share, Nvidia offers incredible liquidity, tight bid/ask spreads, and huge levels of open interest. 

But that’s not the case with every stock option, even ones that offer options that expire every week. 

For example, check out Viking Therapeutics (VKTX). 

The $63 calls expiring in ten days have a spread of $2.85 by $4.30. 

You can drive a truck through that spread!

The volume is low and so is the open interest. 

Understanding Slippage: The Silent Profit Killer

Slippage might sound like some technical jargon, but it's a silent killer of profits. 

It's the difference between the price you expect to get (based on the bid/ask spread) and the price you actually get. 

In illiquid options with wide spreads, slippage can be enormous.

Let's say you decided to buy those VKTX call options at the market price of $4.30. 

To break even by expiration in less than two weeks, VKTX would need to jump by 8.2%. 

That's a hefty move in a short time frame.

If you're trading options with wide spreads and low liquidity regularly, these slippage costs add up and can severely impact your overall profitability.

Market Makers Aren't Trolling You

It's tempting to think that market makers are out to get you with these wide spreads, but that's not the case. 

In low-volume, low-interest options, they're simply managing their risk. Without competition or significant demand, there's no incentive for them to tighten the spread.

Think of it like buying a beer at a football stadium. 

Inside the stadium, you've got limited choices, and prices are sky-high. Outside, you have plenty of options and competitive pricing. 

In illiquid options markets, you're stuck inside the stadium with overpriced beer.

Strategies to Combat Slippage

So, how do you avoid falling into the slippage trap?

  • Focus on Liquid Options: Stick to options with high volume and open interest. These typically have tighter bid/ask spreads.

  • Use Limit Orders: Never use market orders in options trading. By setting a limit order, you control the price you're willing to pay or receive.

  • "Make the Market" Yourself: If you're determined to trade a less liquid option, you can improve the bid or ask yourself. Place a bid slightly above the current bid or an ask slightly below the current ask and see if the market responds.

  • Consider Alternative Strategies: If liquidity is an issue but you still want to trade that instrument, look into spread strategies like In/Out. These can sometimes mitigate slippage costs.

Don't Let Slippage Eat Your Profits

I've heard too many horror stories of traders who got their market direction spot-on but still lost money because slippage and wide spreads ate into their profits. 

It's not just about being right in direction… It's about being smart with execution.

Remember, in options trading, liquidity is king. 

Right now, my focus has been 

Elevate Your Trading with In/Out Spreads

If you're looking for a strategy that helps you navigate the complexities of options trading while minimizing risk, let me introduce you to the concept of In/Out Spreads. 

This is a strategy I've honed over decades in the trading trenches, and it's designed to give you a probabilistic edge.

What Are In/Out Spreads?

They involve buying an option that's "in the money" and selling one that's "out of the money," thereby creating a spread.

Why In/Out Spreads Work

  • Defined Risk: You know your maximum loss upfront.

  • High Probability: These trades have a statistical edge, often winning around 70% of the time.

  • Capital Efficiency: With a low entry cost, you can place multiple trades to diversify your risk.

To your success,

Don Kaufman