By keeping your cool when trading with exchange traded fund (ETF) options, investors can maintain that edge to effectively navigate the capricious waters of the markets.
Price Headley for iStockAnalyst sees that traders make some common mistakes when trading options on ETFs. Headley points to five blind spots:
- No plan prior to trades. Many traders react to rumors, hot tips or daily trends in hopes of making a quick profit. More often than not, potential payoffs are not worth the risk. Headley advises to pass on ETF option trades if the ratio of reward-to-risk is not at a minimum of 2 to 1, or better yet, 3 to 1. By defining a plan in advance, good traders take losses quickly while letting winners run on.
- Too focused on the price of an ETF option. Traders should consider opportunity cost by rotating capital to relatively better performers while selling the non-performers. Or in trader’s lingo, “keep coming back to the stocks that work best” while “exiting non-movers” to put capital in better stocks.
- “Surefire” trading idea? The markets are constantly changing, so a trader should never depend on one idea that may seem “sure” to win. It is a good idea to have a consistent capital allocation method and manage your risk levels.
- 2x leverage on ETFs equals 2x profits on leveraged ETF options? ETF traders need to be acquainted with what leveraged ETFs entail. The main point to know is that leveraged ETF are only meant to create the leverage in the short-term, especially in volatile markets. Over the long-term, high market volatility hurts the performance because of compounding. It’s important to understand how these funds work before you buy.
- “All or none” mindset for ETF options trades. Most people tend to believe they need to sell all or none of a stock. One alternative is to take partial profits at pre-defined points during a trend.
Most importantly, when trading anything, it’s clear that having a pre-defined strategy that you can stick to will serve you well in the long run.
For more information on options, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.