To manage risk when trading options for income, control four things: position size (risk about 1-2% of trading capital per trade), defined risk (use spreads instead of naked short options), diversification across underlyings, and a planned exit for every trade. Options are leveraged, so a small premium can control many shares and a wrong move can wipe out the whole position. The sections below show how leverage changes risk and how each rule limits it. This is educational content, not investment advice.
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Options are generally considered risky investments as without managing the risk properly one can lose the entire capital. However, options can be used to hedge positions and minimize risk while making directional bets.
**Understanding leverage **
Leverage can be used to control the same quantity of shares with a lesser amount of money.
Consider a trader with $10,000 and a $100 stock. The trader has two choices:
1. Use $10,000 to buy 100 shares
2. Use $10,000 to buy 10 call contracts at a $10 premium ($1,000 per contract, each covering 100 shares)
The second choice controls 1,000 shares instead of 100. The risk is very different. In the first case the trader loses everything only if the stock goes to zero, which is unlikely. In the second case, if the stock finishes at or below the strike price at expiry, all 10 calls expire worthless and the whole $10,000 is lost.
To manage the risk, the trader can buy just 1 contract (100 shares) for $1,000 and keep the rest of the capital for other opportunities. This will result in more diversification and will in turn reduce risk.Methods to reduce risk
Now, let us look at some methods that can be employed to reduce risk exposure.
• Using Options spread
Many options income strategies use spreads to manage risk. Buying one option and selling another (for example, a bull call spread) lowers the upfront cost and caps how much you can lose. This means that you potentially reduce the profits you would make, but it reduces the overall risk.
• Diversification
Diversification is used by investors to build a portfolio comprising of different companies and sectors in order to reduce the risk. The underlying idea is the same in options trading, i.e., not to commit too much investment amount in any one investment.
• Position sizing
Position sizing refers to the amount you are willing to enter any particular position. By risking 1-2% of total trading capital per trade, you still have most of your capital after several losses in a row.
• Exit Strategy
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 options contracts. Protective option hedges work like insurance: they cost a premium and limit the damage from a large move.DisclaimerNone of the content published on marketxls.com constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein.** References**
Learn more in this options risk-control and money-management guide.
