3 Strategies To Manage Risk When Options Trading

Options trading is complex, exciting, and potentially profitable. But there’s also no denying that it comes with an inherent risk that buying and selling stocks doesn’t include. There is a reason why many trading experts don’t recommend newcomers to the stock market to try their hands at options trading; there are simply too many things that can go wrong.

That said, there are ways to manage the notorious risk associated with options trading, whether you’re a beginner or an experienced stock market trader. Today, let’s look at three of those risk management strategies for options trading in detail.

Image by Pexels from Pixabay

There’s one surefire strategy you can rely on when trading options, stocks, or any other financial asset: take profit. But while it sounds simple, many traders, both new and experienced alike, fail to adhere to it. Here’s why:

• When you start trading, whether it’s options or stocks, you probably have a financial goal or profit benchmark in mind. For example, you purchase an options contract and hope to make $1000 from the deal.
• When your options contract reaches that $1000 benchmark, you should take your profit, even if the financial forecasts indicate that the profitability of the contract (and underlying stock) will go up.
• Many traders don’t stick to this rule. They get greedy and hope to make more profits, so they hold onto their stocks or options for too long, only to watch their prices decrease dramatically. In the end, traders lose money instead of taking the profit that was already almost in their pockets.

The strategy you should follow instead is this: if you are options trading and you have the opportunity to take substantial profit, do it. Don’t continue to chase higher dollar signs. This can feel tempting in the short term, but you’ll inevitably lose on the market and wish you had taken the profit.

Even in the best circumstances and with tons of experience, you can’t predict how the market will behave or react to changing economic circumstances. Therefore, you should leap at the opportunity to make a profit when you can instead of continuously trying to chase even more money.

There’s another good way to manage risk when options trading: setting and sticking with a “loss cap.”

A loss cap is a price decrease for your options contracts, at which point you decide to abandon the deal or take your losses. For example, you might set a loss cap at $5000 – if your contracts flop up to this amount, you don’t continue to hold onto the contracts or underlying stocks. You sell them or otherwise rid your portfolio of them.

Loss caps are important because they prevent you from having to suffer through even higher losses. No one likes to lose on the market, especially when it comes to options trading. But it’s important to recognize that you will eventually lose money. The key to successful trading is to lose less money than you make in the long term.

By setting and sticking to your loss caps, you’ll mitigate the financial damage your portfolio will have to endure. You’ll thank yourself when you see prices continue to decrease. Even if the price bumps back up and you lament selling, it’s a good idea to remember the big picture. Loss caps help you maintain an overall positive return on investment for your capital over many years, not just a week or month. 

Lastly, you should consider learning how to cover your calls. Covering your calls is one of the best ways to mitigate risk when trading options while still earning substantial profits.

In a nutshell, a covered call is any transaction where you, the investor, sell call options while owning an equivalent amount of the stock or asset the options refer to. For example, say that you have 100 shares of Stock A. Since you own the stock, you have to decide when to sell it (or if to sell it at all).

To make a profit and participate in options trading, you then write call options for Stock A for 100 shares. In doing this, you generate an income stream through your call options (by selling them to other people). If the call option buyer chooses to exercise their options contracts, you already have the shares in hand – you don’t have to take on extra risk by scrambling to buy shares you don’t own.

Covering your calls is a very popular options strategy. You can generate income through options premiums while mitigating your risk because you already own the underlying assets in question. 

Of course, there’s also a downside to this trading strategy: you can’t expect astronomical profits. Still, it can be a great way to make extra money on the stock market and learn the ins and outs of options trading before participating in riskier maneuvers.

Image by Csaba Nagy from Pixabay

Let’s look at a bonus tip to manage risk when options trading before you get started.

Because trading options is so risky, it’s a good idea to read and learn as much as possible about this unique financial trading method before trying your hand at it. Read relevant books, take some classes, listen to podcasts about investing, and be sure you know how to use all of the tools for your broker or trading platform before buying your first option.

The more time you spend learning how to trade options, the less risky your trades will be. In contrast, many new traders – lured by the promise of easy profits and accessibility – lose tons of money when trading options because they don’t fully understand what an options contract means or how it works. 

For instance, one of the most common mistakes that new options traders make is failing to understand that if they sell an options contract and the buyer exercises the contract, they (the contract sellers) are on the hook for procuring and providing that stock to the buyer.

Bottom line: be sure to consume plenty of educational materials and get some basic trading experience under your belt before trading options at all.

As you can see, trading options means coming up with a plan, sticking to it, and using clever strategies to mitigate risk while collecting profit. Anyone can get lucky on the stock market, especially with options trading. But only those who utilize the right risk management strategies will stand to keep the money they make for the long haul. Consider incorporating these tips into your options trading strategy today.