When risk management for options trading is a primary focus of your trades, you’re in the right headspace.
Everyone hears how risky options are. And options certainly can be very risky.
On the other hand, options can reduce both trading and investing risk. In this article, I’ll share several insights that enhance risk management for options trading.
Selling Options Vs Buying Options
You can accomplish similar goals by using puts vs calls. For example, selling a put can have a similar result to buying a call. Many traders get caught up in which strategy makes more sense.
What I want to emphasize is this: the best risk management for options is to be a seller instead of a buyer, period.
When you sell options vs buying options, the probabilities are immediately and hugely in your favor, as I write about in other posts here.
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Risk Management for Options Trading with Diversification
Diversification is one of the soundest principles when it comes to your money. This is true for investing as well as trading. Don’t ever put your eggs in one basket.
The simplicity of managing only a couple of trades vs ten positions is a frequent lure to avoid adequate diversification.
Then there’s the temptation to go all in when a trade looks like there’s no way it can lose money.
It’s fine to master and stick to one strategy, such as credit spreads or butterfly spreads. This can even be a benefit to master your skills around that one option strategy. Diversifying among companies or ETFs can improve your risk management for options trading.
Using Position Size for Risk Management
Position size can be one of the biggest risk management factors. This risk factor relates closely to diversification. One position can easily become disproportionate to your other positions, especially with all the variables relating to option pricing.
Do your best to keep the amount of capital and risk allocated close the same level for each of your positions.
As you can imagine, if the one huge position turns into a losing trade, you can give back all your profits for the month, or worse.
Trading Plans Improve Risk Management
Create a trading plan when you are away from the heat of the markets. Your plan will have the rules that you create for yourself. This can include:
The amount of investment capital allocated to your trading account
The hours and days you will trade
The amount of loss you’ll allow
The number of trades you’ll place
The dollar amount allocated to each trade
The risk you’ll allow
Print your trading plan and review it quickly each day. These are the guidelines you have created for trading success.
Allocate a Prudent Portion of Your Investment Money to Options
A core portfolio allocated among stocks, bonds, commodities or real estate can lose its luster for options traders. While I must admit, long-term buying and holding the S&P 500 index isn’t too sexy, especially in the “second half” of life when you know it can take decades for real wealth accumulation. On the other hand, it’s extremely unlikely you’ll lose all your money in these financial staples.
Not only does a core somewhat boring portfolio in traditional investments make sense for many, I encourage this. Allocate a smart portion of your investment funds to options trading and no more. If you are married, be on the same page with your spouse if you want to keep a good relationship.
No one likes to admit to losing trades, but they are a fact of life. Every investor and every trader lose money at times.
Traders can be lone rangers, feeling as though they don’t need to share their trading with significant others. I disagree. This can be a recipe for disaster. Relationships come first. Keep it that way in your mind.
Keep your net worth statement current. Include the value of your home and other major assets. Deduct all your liabilities. Then and only then can you choose a wise amount to put in your trading account.
Paper trading is one of the smartest risk management tools for options. Let’s face it; options aren’t mastered in a day. Paper trading can turn amateurs into seasoned pros. There is no shame in paper trading, only smarts. Confident investors are cool with this.
Keep reading or grab my free eBook Option Trading Made Simple below
Risk management for Options Tools
There are so many free tools available through your brokerage platform. These tools can significantly increase the probability of winning trades. I’ll admit that I’m partial to the proprietary trading indicators I developed after decades of trading. But if you’re not yet ready for my system, use the free tools that can lower your risk by simply increasing the probability of winning trades.
Tools that are probably free on your brokerage platform include:
- Theta to measure Time Decay
- Delta to measure price movement relating to the underlying security
- Gamma to measure the speed of Delta
- Implied Volatility to help you forecast price movement
- Set Stop Losses
It takes pride to close out a losing trade. The nature of trading is to hang on, thinking the trade will turn around. The key here Is to realize that you can and will have trading losses. By controlling your losses, you’ll be able to come out ahead. Set a loss limit and hold firm to it.
Invest in Your Knowledge
Knowledge is power. Think back on all the things you have mastered in your life. Then think about the difference in performance between when you knew very little and when you knew a lot. We are all better at things we have in-depth knowledge about.
If you’re going to put your money into trading, spend a little money mastering the skills to succeed. Knowledge significantly reduces risk.