Risk & Money Management in Option Trading
Correctly managing your capital and risk exposure is essential when trading options. While risk is essentially unavoidable with any form of investment, your exposure to risk doesn’t have to be a problem. The key is to manage the risk funds effectively; always ensure that you are comfortable with the level of risk being taken and that you aren’t exposing yourself to unsustainable losses.
The same concepts can be applied when managing your money too. You should be trading using capital that you can afford to lose; avoid overstretching yourself. As effective risk and money management is absolutely crucial to successful options trading, it’s a subject that you really need to understand. On this page we look at some of the methods you can, and should, use for managing your risk exposure and controlling your budget.
- Using Your Trading Plan
- Managing Risk with Options Spreads
- Managing Risk through Diversification
- Managing Risk using Options Orders
- Money Management & Position Sizing
Using Your Trading Plan
It’s very important to have a detailed trading plan that lays out guidelines and parameters for your trading activities. One of the practical uses of such a plan is to help you manage your money and your risk exposure. Your plan should include details of what level of risk you are comfortable with and the amount of capital you have to use.
By following your plan and only using money that you have specifically allocated for options trading, you can avoid one of the biggest mistakes that investors and traders make: using “scared” money.
When you are trading with money that you either can’t afford to lose or should have set aside for other purposes, you are far less likely to make rational decisions in your trades. While it’s difficult to completely remove the emotion involved with options trading, you really want to be as focused as possible on what you are doing and why.
Once emotion takes over, you potentially start to lose your focus and are liable to behave irrationally. It could possibly cause you to chase losses from previous trades gone bad, for example, or making transactions that you wouldn’t usually make. If you follow your plan, and stick to using your investment capital then you should stand a much better chance of keeping your emotions under control.
Equally, you should really adhere to the levels of risk that you outline in your plan. If you prefer to make low risk trades, then there really is no reason why you should start exposing yourself to higher levels of risk. It’s often tempting to do this, perhaps because you have made a few losses and you want to try and fix them, or maybe you have done well with some low risk trades and want to start increasing your profits at a faster rate.
However, if you planned to make low risk trades then you obviously did so for a reason, and there is no point in taking yourself out of your comfort zone because of the same emotional reasons mentioned above.
If you find it difficult to manage risk, or struggle to know how to calculate the risk involved in a particular trade, you may find the following article useful – Understanding Risk Graphs & Risk to Reward Ratio. Below, you will find information on some of the techniques that can be used to manage risk when trading options.
Managing Risk with Options Spreads
Options spreads are important and powerful tools in options trading. An options spread is basically when you combine more than one position on options contracts based on the same underlying security to effectively create one overall trading position.
For example, if you bought in the money calls on a specific stock and then wrote cheaper out of the money calls on the same stock, then you would have created a spread known as a bull call spread. Buying the calls means you stand to gain if the underlying stock goes up in value, but you would lose some or all of the money spent to buy them if the price of the stock failed to go up. By writing calls on the same stock you would be able to control some of the initial costs and therefore reduce the maximum amount of money you could lose.
All options trading strategies involve the use of spreads, and these spreads represent a very useful way to manage risk. You can use them to reduce the upfront costs of entering a position and to minimize how much money you stand to lose, as with the bull call spread example given above. This means that you potentially reduce the profits you would make, but it reduces the overall risk.
Spreads can also be used to reduce the risks involved when entering a short position. For example, if you wrote in the money puts on a stock then you would receive an upfront payment for writing those options, but you would be exposed to potential losses if the stock declined in value. If you also bought cheaper out of money puts, then you would have to spend some of your upfront payment, but you would cap any potential losses that a decline in the stock would cause. This particular type of spread is known as a bull put spread.
As you can see from both these examples, it’s possible to enter positions where you still stand to gain if the price moves the right way for you, but you can strictly limit any losses you might incur if the price moves against you. This is why spreads are so widely used by options traders; they are excellent devices for risk management.
There is a large range of spreads that can be used to take advantage of pretty much any market condition. In our section on Options Trading Strategies, we have provided a list of all options spreads and details on how and when they can be used. You may want to refer to this section when you are planning your options trades.
Managing Risk Through Diversification
Diversification is a risk management technique that is typically used by investors that are building a portfolio of stocks by using a buy and hold strategy. The basic principle of diversification for such investors is that spreading investments over different companies and sectors creates a balanced portfolio rather than having too much money tied up in one particular company or sector. A diversified portfolio is generally considered to be less exposed to risk than a portfolio that is made up largely of one specific type of investment.
When it comes to options, diversification isn’t important in quite the same way; however it does still have its uses and you can actually diversify in a number of different ways. Although the principle largely remains the same, you don’t want too much of your capital committed to one particular form of investment, diversification is used in options trading through a variety of methods.
You can diversify by using a selection of different strategies, by trading options that are based on a range of underlying securities, and by trading different types of options. Essentially, the idea of using diversification is that you stand to make profits in a number of ways and you aren’t entirely reliant on one particular outcome for all your trades to be successful.
Managing Risk Using Options Orders
A relatively simple way to manage risk is to utilize the range of different orders that you can place. In addition to the four main order types that you use to open and close positions, there are a number of additional orders that you can place, and many of these can help you with risk management.
For example, a typical market order will be filled at the best available price at the time of execution. This is a perfectly normal way to buy and sell options, but in a volatile market your order may end up getting filled at a price that is higher or lower than you need it to be. By using limit orders, where you can set minimum and maximum prices at which your order can be filled, you can avoid buying or selling at less favourable prices.
There are also orders that you can use to automate exiting a position: whether that is to lock in profit already made or to cut losses on a trade that has not worked out well. By using orders such as the limit stop order, the market stop order, or the trailing stop order, you can easily control at what point you exit a position.
This will help you avoid scenarios where you miss out on profits through holding on to a position for too long, or incur big losses by not closing out on a bad position quickly enough. By using options orders appropriately, you can limit the risk you are exposed to on each and every trade you make.
Money Management and Position Sizing
Managing your money is inextricably linked to managing risk and both are equally important. You ultimately have a finite amount of money to use, and because of this it’s vital to keep a tight control of your capital budget and to make sure that you don’t lose everything and find yourself unable to make any more trades.
The single best way to manage your money is to use a fairly simple concept known as position sizing. Position sizing is basically deciding how much of your capital you want to use to enter any particular position.
In order to effectively use position sizing, you need to consider how much to invest in each individual trade in terms of a percentage of your overall investment capital. In many respects, position sizing is a form of diversification. By only using a small percentage of your capital in any one trade, you will never be too reliant on one specific outcome. Even the most successful traders will make trades that turn out badly from time to time; the key is to ensure that the bad ones don’t affect you too badly.
For example, if you have 50% of your investment capital tied up in one trade and it ends up losing you money, then you will have probably lost a significant amount of your available funds. If you tend to only use 5% to 10% of your capital per trade, then even a few consecutive losing trades shouldn’t wipe you out.
If you are confident that your trading plan will be successful in the long run, then you need to be able to get through the bad periods and still have enough capital to turn things around. Position sizing will help you do exactly that.