Options trading can be a lucrative way of diversifying your investment portfolio. Like any investment, there is always a degree of risk involved, and options trading is no exception. Due to the typically short time frames options traders work on, options trading often gets a bad reputation for being a high-risk activity. We’re here to tell you why that may not be the case!
Before we begin, it’s important to understand that there’s a difference between risk management and zero risk. You can never completely eliminate all risks involved with options trading, but you can minimize that risk through an effective risk management strategy. Below, we’ll discuss how to build a strategy that works for you.
Understanding Risk in Options Trading
If you are new to options trading, you may be wondering what about options trading makes it risky. There are two ways to trade options, each with its pitfalls and benefits: buying or selling. Most of the risk associated with it comes from selling an option. That’s because there’s no cap for potential losses. When you buy an option your risk is set at whatever premium you bought that option for. Selling options on the other hand have you receiving that premium upfront and either buying or selling the asset at strike price, meaning that your potential for loss is theoretically unlimited.
Whenever you are dealing with the market, there’s always a degree of risk that results from market volatility. That volatility could impact you for instance if you choose to sell an option but the market decides to move against your position.
Another thing to consider is because options work on a deadline, as the time to that deadline approaches, your option will naturally appreciate. It’s important to have an idea of where the chosen stock will move and the timing of your timeline.
Elements of Options Risk Management
So how can we mitigate some of that risk? There are a few options that are available to us. The first thing you should consider is what your personal objectives are when it comes to investing. Ask yourself what your risk tolerance is and what goals you may have.
Once you’ve done that, the second step is to spread your risk across a portfolio. The old adage of ‘never put all of your eggs in one basket’ applies here. A good investment portfolio is made of a mix of investments ranging from stocks and bonds to options and real estate. The more diverse your portfolio is, the easier it is for you to recover from losses.
You can look at this idea when just viewing options as well. Where are your options coming from? Spread out, and learn about other options that may be out there. This, along with any other investments you make, should be an appropriate size for your personal objectives.
When we say size, we refer to how much capital is being allocated to the asset, what is the size of the trade, and what position does it take?
Strategies for Effective Risk Mitigation
Now that you’ve set clear objectives for yourself, you can come up with a strategy for mitigating the risk of your options trading. There are several ways you can do this.
- Stop-Loss Orders
- Risk-Reward Ratios
Let’s take a closer look at each.
A stop-loss order is a risk management tool where you set a certain price below the market price and your option sells automatically to limit the potential loss.
When you hear hedging, a common phrase is to ‘hedge your bets. Hedging an option is when you buy an option to offset the risk to any already existing trade. If you see the market possibly going either way, hedging your bet would mean purchasing or selling several options that could take advantage of either outcome.
Performing a risk-reward ratio analysis entails the anticipated returns of an option to the potential loss. Take those two numbers and divide them by each other to get your ratio.
It’s a Learning Process
Remember that options trading is overwhelming to everyone when they are getting started. A great rule of thumb when investing is to never invest in something you don’t understand. Safe Options Strategies helps you not only understand options trading with our extensive education programs but also guides you in making less risky choices with higher yields.