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Managing Options Trading Risk


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The Basics of Managing Options Trading Risk

Managing Options Trading RiskManaging Options Trading Risk is very important because trading options carries the risk of losing all of the trading capital committed to trading options, since options can expire worthless if their strike price is not achieved prior to the option expiration date.  To mitigate this risk of total trading capital loss, there are a number of options trading strategies that can employed for managing options trading risk.

What really makes options interesting and useful from a risk management prospective is that unlike stocks, managing options trading risk can be absolutely defined when an options trader executes a well designed risk management options trade.  In other words, a well designed risk management options trade will limit an options trader’s risk of capital loss to a fixed amount that the trader can calculate.  This is done by buying and selling various types of options to cancel out the potential for an option to expire worthless upon expiration.  Such a strategy limits profit potential when trading options, but the trade off is well worth it to options traders looking to protect trading capital in the event that the options that they hold do not hit their strike price upon expiration.

Strategies for Managing Options Trading Risk

Managing options trading risk involves the execution of a number of different well designed risk management options trades.  The type of options trade utilized to manage risk in a particular situation depends upon the objective of the options trade, current market circumstances, and the anticipated move that an options trader expects from the underlying stock or commodity on which an option is based upon.  The following is a list of options trading strategies for managing options trading risk.

  • Option Straddle An option straddle involves buying a call option and put option at a stock or commodity’s current trading price with same strike price and month for both options.  A profit can be made on an option straddle if the stock or commodity moves above or below the strike price enough to cover the premium paid for the put and call options.  There is a risk of losing the premium paid for the options, if the stock or commodity does not move away from the options strike price before expiration; therefore, an option straddle should be used during times of market volatility and uncertainty.
  • Option Strangle An option strangle involves buying the same quantity of a call option and a put option for the same stock or commodity, but at different strike prices that are away from a stock or commodity’s current trading price, which are known as “out of the money” options.  While a premium is paid to create an option strangle trade, that premium is protected by the opposing option positions, as either the call or put option will gain in value as the stock or commodity moves up or down in price.  A strangle option trade is usually less expensive than a straddle option trade since “out of the money” option contracts are less expensive than option contracts that are at the current trading price of the underlying financial instrument.
  • Option Ratio Spread – An option ratio spread involves buying a quantity of call or put options and selling a quantity call or put options for the same stock or commodity and the same expiration date, but at different strike prices.  If an options trader is expecting a stock or commodity to increase in price, they would initiate an option ratio spread trade by buying a greater number of call options at or near the current trading price and then selling a lesser number of put options at a higher strike price.  An options trader would do the opposite if they are expecting a stock or commodity to decrease in price.  The premium paid for an option ratio spread is reduced by selling puts when initiating a long option ratio spread and selling calls when initiating a short option ratio spread.  The premium paid for an option ratio spread is protected by the opposing option positions.

Those who wish to trade options are encouraged to learn as much as possible about managing options trading risk and the various ways options can be traded.

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