Risk Management with Options

Many investors mistakenly believe that options are always riskier investments than stocks because they may not fully understand what options are exactly and how they work. Options, in fact, can be used to hedge positions and reduce risk, such as with a protective put. Options can also be used to bet on a stock going up or down, but with relatively less risk than owning or shorting the actual equivalent in the underlying stock. This latter use of options to minimize risk in making directional bets will be the focus of this article. Read on to learn how to calculate the potential risk of options positions and how the power of leverage can work in your favor.

Here are five ways to effectively manage risk as an option trader:

• The first step in managing risk as an option trader is position sizing. When buying options the amount of capital you spend buying an option contract long is the most you can lose if your option expires worthless before expiration. The best way to avoid the risk of ruin when trading options is to never put on a position size greater than 1% to 2% of your total trading capital. If you have a $50,000 option trading account your maximum option trade should be $500.
• When selling option contracts to open your risk can be theoretically unlimited unless you buy a farther out option as a hedge. Using fix loss option plays is important so you cap the amount of your losses if a strong trend moves against your short option. You should buy your hedge at the location of price you want to cap losses at.
• If you sell a covered call your risk is in the stock. You can set a stop loss for your stock position where you will cut your losses short and buy to cover your short call.
• If you sell a married put your risk is in the short stock. You can set a stop loss for your short stock position where you will cut your losses short and buy to cover your short stock and buy to close your short put option.
• Do not put on option plays with open risk or undefined risk. It is very dangerous to expose yourself to uncapped and unlimited risk selling options short, the odds are that eventually you will be ruined on one outsized move. Always have an exit strategy when you sell option contracts. Option hedges are insurance that will pay for their self over the long term.
• Options and Leverage

Let us first consider the concept of leverage, and how it applies to options. Leverage has two basic definitions applicable to options trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into the most trouble. A dollar invested in a stock, and the same dollar invested in an option does not equate to the same risk.

The second definition characterizes leverage as maintaining the same sized position but spending less money doing so. This is the definition of leverage that a consistently successful trader or investor incorporates into his or her frame of reference.

• Options contracts can be used to minimize risk through hedging strategies that increase in value when the investments you are protecting fall.
• Options can also be used to leverage directional plays with less potential loss than owning the outright stock position.
• This is because long options can only lose a maximum of the premium paid for the option, but have potentially unlimited profit potential.