Monday, June 17th, 2019

Risk Management in Option Trading

November 26, 2009 by T.D. Thompson  
Filed under Options Trading Tips

 

In option trading there is always risk and there is always the potential for reward. If option trading is your business you will always have losers as well as winners. The goal of successful options trading is to win more than you lose, hopefully a lot more than you lose. You win in doing option trading by research, attention to detail, and by risk management.

The most effective risk management in option trading is not to trade. If, for whatever reason, you are not really sure of the trade, don’t. However, even when you are absolutely sure of what you are doing in option trading you need to practice risk management.

Risk management in option trading has to do with knowing that predicting an underlying stock’s price has to do with probabilities and not certainties. Risk management in option trading also has to do timing and if you use hedge strategies such as a straddle option to limit your risk.

As in trading a stock or other commodity you know the price at the moment and try to predict the future. If you are “in the money” with an option then you can exercise the option and make money. If you are “out of the money” then you can exercise the option and cut your losses or you can wait for things to, hopefully, improve.

One risk that is hard to control is the so called pin risk. When a stock is within minutes of its expiration date it may be trading at or near its strike price. If you the buyer of the option, whether it is a put or a call, you can control the situation by trading your option but if you are the seller you could be in trouble.

Let’s say that you sold a put option on a stock in the belief that the stock would go up or stay at the same price. You do not own the stock so are engaging in naked options trading. Your plan would be that you would gain the premium and the buyer would not exercise the option. However, if the stock creeps below the strike price at the last minute you could be stuck. The buyer of your put option may exercise it before expiration and you will need to buy the stock at a strike price which is now above the market or spot price. If you liquidate the stock you will need to sell at the lower stock value. If the stock drops a few percent in value you could end up with a substantial loss.

Your best protection is to stay out of this kind of option trading unless you have substantial assets to back you up and substantial experience in picking absolutely the right stocks, bonds, or other underlying securities. One bad trade early in the game can wipe out your capital with bad risk management. This gets back to our original suggestion. If you are not absolutely sure of what you are doing and the risks involved stay out of option trading where there is the potential for substantial loss. Stick with buying call options and put options where the risk is the premium and the market has the potential to reward you substantially.

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