The 5 Mistakes Option Sellers Make (and How To Avoid Them)

We’re all creatures of habit — but some habits are worth breaking. Option sellers of every level tend to make the same mistakes over and over again (including myself). But here is the good news! Most of these mistakes could have been easily avoided.

With this article, I document the mistakes that I have made so that my readers do not to have to re-learn from my lessons.

Mistake #1 - Not Having An Exit Plan

When it comes to navigating the thrilling world of options selling, relying on emotions to make exit decisions is like playing with fire. Engaging in such risky conversations can lead to catastrophic damage to your portfolio, leaving you in a lengthy recovery battle.

It is not uncommon for some to have these conversations in their heads:

"Maybe if I wait a bit longer, my position will recover" or

"My option position is already 50% profit in just two days – maybe I should wait longer to collect more profit."

The use of the word "maybe" hints at the absence of a well-defined exit plan, a dangerous situation where decisions are driven by emotions rather than a sound, logic-based strategy.

For me - here's are my rule-based exit plans.

Taking Profit. Ka-ching! That's that sound of taking profits. For me, I typically take profits when my options hits hits a 50%. For example, if I were to sell a put option for $1.20, I would buy back the position at $0.60 – that's the sweet spot for profits - and I would then recycle the profits to the next high probability trade.

Cutting Losses - Rule 1.  If the trade breaks through the resistance (for bearish trades) or support (for bullish trades), it's a clear signal that I need to start monitoring the trade. For me, I monitor the trade by looking at the margin of safety (i.e. the distance between the current share price and the strike price). In such scenarios, I stand ready to reassess and recalibrate my strategy before the positions bleed further. At times, I will simply reduce my positions by closing some contracts, or even close them completely.

Cutting Losses - Rule 2. Another rule for cutting losses comes into play when my option spread dips into a 200% loss. To illustrate, suppose I sold a Put Option for $1.20; in this scenario, I make the decisive move to cut my losses as soon as the option price hits $3.60, translating to a $2.40 loss upon repurchasing the option.

In the electrifying realm of options trading, there may be no hard and fast rules, but my approach allows me to me logical and swift decision to protect and grow my portfolio.

Mistake #2 - Trading Non-Liquid Options

Okay, here's a lesson from one of the battle scars I had.

When you're selling options, there's this thing called the Bid price (how much someone wants to pay) and the Ask price (how much someone wants to sell for).

Let's talk Bid and Ask Spread with a fun example!

See, the bid and ask prices might not show the real worth of the option. The "real" value is usually in the middle of the bid and ask.

Now, think of "liquidity" as a party in the market with lots of people buying and selling stuff. When it's a crazy fun party, the bid and ask prices for stocks and options get close.

But, here's the twist: when the bid-ask spread is big (like a wide gap), it's like a puzzle to close your option deal - where it becomes incredibly hard for someone to buy over your option. I once had a super sweet 60% (paper) profit on my Bull Put Spread, but the bid-ask spread was so wide, I couldn't close it!

Remember, wide spread means harder to close.

So, how do we avoid this tricky situation?

Here's the secret: I have this rule of only selling options with a bid-ask spread less than a dollar. It's like making sure the game is easy to play.

As a rule of thumb, stocks have a mega 3M average trading volume usually have a tighter bid-ask spread!

Mistake #3 - Poor Portfolio Sizing

Survive to trade another day! Avoid the trap of being too greedy and making gigantic trades.

The idea of "Go big or go home" doesn't fly here. Don't imagine you're a the God of Gamblers, thinking you can win big by just going all in.

Even though selling options has a super high win rate, going crazy big on one losing trade can turn your whole portfolio upside down.

Here's my game plan:

(1) I play it safe by limiting to 10% margin per option position.

(2) I ensure that I only have a maximum of 3 to 5 open positions (i.e. limiting my margin use to only 30% to 50%).

When your net liquidation falls below the maintenance margin in a margin trading account, it triggers a situation known as a margin call - where your broker may force liquidate your assets (and force you to take a loss).

Remember that maintenance margin will fluctuate based on the underlying share price's movements - this is why it is conservative to keep at least a 50% maintenance margin when sell options.

Mistake #4 - Holding Trades Through Earnings

Here's another newbie mistake - holding your trade through earnings. Let me explain why.

Imagine the stock market is a big playground, and companies are like kids with lemonade stands. Every few months, these companies, just like you and your friends, gather to spill the beans on how well their "lemonade stands" (or businesses) are doing. That special time is called earnings season.

Now, here's where it gets interesting. When a company announces it made more money than everyone thought, it's like saying they sold a ton of lemonade! People get super excited and want to buy their "lemonade stand stocks." But, if things aren't as sweet as expected, people might get a bit worried, just like when a friend's lemonade stand doesn't do so well - people may want to sell away their "lemonade stand stocks".

So, during earnings season, the playground (stock market) can turn into a bit of a rollercoaster. The prices of these "lemonade stand stocks" can go up really high (spikes) or down pretty low (falls). It's like a wild ride for the grown-ups in the stock market, and the excitement or worry about how well the companies did is what makes the prices go a little crazy!

That's why, a month before earnings season, I play it safe and sell only a few options. I don't want to be on that rollercoaster holding onto my sold options when the lemonade news comes out. It's just too risky!

Here's an example where META  spiked over 19% in just a day when they reported their earnings.

Imagine if I was holding a  a sell call option - I would have probably lost over thousands of dollars.

This is why I do not want to hold my sell options positions through earnings, and I don't recommend anyone to do so - it simply isn't worth the risk.

The only exception to this rule - is if you have a Term Insurance strategy to help you tide through any abrupt price movements.

Mistake #5 - Not Having Strict Entry Rules

Now - for the last and (possibly) the most critical mistake most people make. Avoiding this is like the secret sauce to winning in the stock market!

When it comes to selling options, I don't play the gossip game. No way! You won't catch me saying, "Oh, I heard Stock XXX is going to soar next week," or "Insiders say Stock ZZZ is headed for a nosedive."

Nope, we don't want to make decisions based on chatty rumors.

Instead, I stick to my guns and follow some super strict entry rules. It's like having a treasure map that guides me to a high win rate. So, what's on this map, you ask? Well, I've got a checklist of questions I need clear answers to before opening into a trade:

1. What's the chance the option will be Out of The Money (i.e. Delta)?
2. What is the current trend of the stock?
3. Where's the next support/resistance levels?
4. What's the Stochastics level - is it optimised for entry?
5. When's the next earnings date for the stock?
6. How much premium am I aiming to collect when I sell the option?

These questions are my superhero tools before I even think about entering the trade. 

Now clearly, I cannot cover all of these topic within one blog post - so why not check out the Options Cheatsheet below where I explained more on these topics!