One of the critical components to making money on options trading is understanding your emotional state. If you do not understand how emotions work, especially the negative kind, then it will be challenging, if not impossible, for you to make money.
Options are derivatives with two defining characteristics: First, they derive their value from another security. Secondly, options allow the holder to buy or sell the underlying stock at a preset price. This choice gives them leverage, which is why trading in options can be so risky, even though you put up less capital for an option than for the actual asset it represents.
Traders who deal with these instruments often have strong emotional reactions that are not entirely rational. For instance, some investors believe that being out-of-the-money (OTM) is always worse than being in-the-money (ITM).
Traders need to be able to identify their emotions when looking at trades. Are you taking losses because of fear? Are you initiating too many positions because of greed? Do not let your feelings control your trading choices; instead, try to understand them and use that understanding to help guide yourself through the markets.
When you are Out-of-the-money (OTM)
Sometimes, being OTM might feel ‘worse’ than being ITM because the buyer of the options is not getting the exposure they intended. For instance, if someone buys a call option on oil with an expiration date in September, they are hoping that oil will be trading well above its current price by then. If this does not happen before the expiration date, both their potential profit and loss are capped at the strike price of $50/barrel.
Understanding these emotions can help traders manage risk more effectively and avoid reacting emotionally to losses. Another reason why OTM options might feel worse lies in human habits. People focus more on avoiding losses than making profits. As such, it feels better to buy an ITM option that gives some exposure to the upside, even if it means giving up more of your investment.
A trader can have irrational feelings about being OTM but still want to control these emotions by setting appropriate stop-loss orders. This way, they won’t be emotionally affected when their option expires OTM. As far as ITM options are concerned, traders often pay too much attention to extra ‘green’ on their screen and forget what this price represents.
For example, let’s assume that an investor buys 100 shares of XYZ company at $50/share with a target price of $70/share. If XYZ trades above or below that price before expiration, both gains and losses are capped at the current stock price. No matter how many green ticks they have on their screen, the investor cannot lose more than $50/share. However, if the price falls below this point, a loss is incurred.
When you are In-the-money (ITM)
Traders can apply a similar strategy with ITM options by setting target prices and stop-loss orders. This way, they can control risk without being emotionally affected by how many green ticks are displayed on their screens.
It might feel worse to be OTM than ITM because of human habits or poor stop-loss discipline, even though both strategies should be treated equally from a trading perspective. However, traders should still aim to implement sensible trading strategies and use appropriate targets and stops to ignore these feelings and make profitable trades. That way, they won’t hand over their investment gains to their emotions.
Finally
At its core, options trading is like any other type of trading. When you’re trying to make money by guessing what will happen with the underlying security (the stock). If trader emotions are interfering with your trading, reexamine why you got into this business in the first place. If you’re looking to make money, then it’s simply a numbers game at that point. New traders are advised to use a reputable online broker from Saxo Bank and trade on a demo account before investing real money. For more information on their services and products, view page here.
