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9 Weeks to Better Options Trading: 5 Rookie Mistakes to Avoid Like the Plague

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Veteran options trader Steve Smith identifies five pitfalls that options traders need to know about -- and avoid at all costs.

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2. Failing to Understand Implied Volatility

Being wrong on a stock's direction is clearly an easy way to lose money. But there's a second, and perhaps even more frustrating way to lose money with options: failing to understand the intricacies of option pricing.

One of the biggest mistakes new options traders make is not taking into account implied volatility, which is a measure of the expectation or probability of a given size move within a given time frame. Put simply, implied volatility provides a gauge as to whether an option is relatively cheap or expensive based on past price action in the underlying stock, and it is among the most important components in option pricing.

For example, options on banks JPMorgan (NYSE:JPM) or Goldman Sachs (NYSE:GS) are relatively expensive, as the implied volatility for March options is running around 30% -- or about double the 16% historic, or real 20-day volatility. This can be explained by nervousness surrounding the big banks' exposure to the economic crisis in Europe.

By comparison, Microsoft's (NASDAQ:MSFT) March options carry an implied volatility of just 19.5%, while the 20-day historic volatility is running at 21%, making the options relatively cheap.

I can't tell you how many times I've heard traders say "options don't work" because they bought puts or calls ahead of earnings, were right on the direction of the stock post-earnings, but the option barely changed in price implied volatility declined post-earnings as is common after expected news events.

Therefore, in order to consistently make money trading options, one must attain a basic understanding of implied volatility. But have no fear – in the coming weeks, I'll be going over ways to both harness and profit from changes in implied volatility.
No positions in stocks mentioned.

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