Managing Your Risk in Options Trading

July 19, 2009 by  
Filed under Options Trading

Every type of investment carries some level of risk, but there are also several types of risks to consider. Managing your risks in options trading can both maximize your net profits and lower your level of losses.

Price uncertainty and volatility is the primary risk in any market investment, since we never know whether a price is going to rise or fall, and by how much. Much like bonds and futures, options carry one additional risk that they will eventually expire.

If action isn’t taken by that date, your entire investment is lost. However, this may at times be the best option if the price drops considerably after buying the option and you risk losing much more than just your initial investment.

You must always account for the uncertainty in the size of the price movement and account for volatility. Volatility means that any investment may drastically change at any moment, for better or worse. This is how both your profits and losses are incurred.

As an options trading participant, you must realize that options are actually a form of risk management. Because you are able to leverage your dollars and control part of an asset without outlaying a ridiculous sum of money to simply buy shares of stock, you are risking less.

This leverage is the most helpful way to alleviate and manage risk. Let’s assume that you want to buy 100 shares of a stock that is currently priced at $400 a share. This amounts to a $40,000 investment, and most of us just can’t swing this type of cash around.

However, you can purchase options for the same stock, without owning them, for just a few dollars per share. Options are typically bought and sold in standard lots of 100, so a $20 option premium would cost you $2000. Now, you can hold the investment for an allotted period of time and control it without ever actually owning the stock.

This type of risk management allows you to keep most of your cash and manage the amount of principal you are risking. Perhaps you could afford the $40,000 investment in the stock shares, but can you afford to lose it all?

Although it’s not common, it is always quite possible when accounting for the affect of volatility on the daily market. Conversely, the $2,000 in options can still provide profit opportunities based on changes in the stock price without risking so much capital.

Before investing in stock options, you first need to consider every risk factor involved. Several options trading software programs will do this for you, without you needing to conduct complicated mathematical calculations. The Greeks, delta, theta, vega, volatility and others, are helpful in quantifying this risk to determine if you can actually afford it in said transaction.

It may also be helpful to peruse online option trading sites and forums to discover how other novice investors are learning the ropes of risk management. Ask a ton of questions and verify the information you’re finding before employing any of these risk management strategies.

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