Benefit of Defined Risk Strategies
Traders have to ask themselves ‘Do I want to risk much in undefined strategies or do I want to risk less and use defined risk strategies?’.
When you Trade small risks strategies it has small profits. If you want to risk more it comes with bigger profits. What you do and the profits you make all depends upon the amount of risk you like to take. How should you choose your trading style?
Of course as a trader you want to make as much as money as possible. That means you have to risk more to gain more. Higher risk strategies have a bigger return, and low risk strategies has a smaller return.
How much risk suits you
What should you choose a low risk strategy or a high risk strategy? Selling naked puts with low priced stocks is not risky, while selling puts with expensive stocks can have a big impact on your portfolio. If you sold a put of the Priceline Group which is $1.186 and it stock drops 10% it may cost you several thousand dollars. If you have a small portfolio than you have the risk that you are wiped out. On the other hand if Zenga ZNGA $3.06 drops 10% it wont hurt you. What kind of risk does suit you? If you have a small portfolio sell only low price naked puts, that is a good way to sell option premium. If you make a lot of trades with a small profit it will add up. When you experience a loss so now and than it will only be a small loss. If you trade big than you experience bigger losses and it will take a long time to recover.
If you are new to options trading and / or you have a small trading account you should start with defined risk strategies.
Defined Risk or Undefined Risk
While selling naked options have undefined risk. It is not quit undefined. In general stocks doesn’t move more than 2 standard deviation. But it is still a lot when you have expensive stocks and it will have a big impact on your portfolio. You might prefer to sell options or option strategies with lower risks. This kind of Low Risk Strategy is called defined risk strategy. If you want to trade expensive stocks or you when you start trading You might start with this kind of strategy.
Defined Risk Strategies
Defined risk strategies are also called low risk strategies. With low risk strategies you are risking less money then with other strategies. Obviously you don’t trade with a high number of contracts. What kind of easy low risk strategies are there?
- Covered calls
- Vertical Spreads
All though there are many more low risk strategies we stay with the above two mentioned because the other are ones are more complex.
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument. This strategy has the same payoffs as writing a put option. Because with selling options you receive a credit, the option will decay over time and if it stays out of the money the option expires worthless. The risk of this trade is when the price of the underlying jumps up.
Vertical spreads, is a defined risk strategy done with either calls or puts. It involves buying one option and selling another option of the same type and expiration, but with a different strike price.
A bull call spread is a vertical spread, it is buying one call and selling one with a higher-strike price. This type of spread would be done for a debit, to offset some of the premium cost. A bear call spread would entail selling the lower-strike call and buying a higher-strike call to hedge the risk. You will get a credit in your account; cash will be held as a margin for the position.
When you are new to trading vertical spreads have a look at Tasty Trade. You’ll see how Tony instruct Case a newby trader the basics of a low risk strategy with vertical spreads.
A Bear Put Spread vertical spread. The trader is assuming that the price of the underlying will go lower. You may buy a put spread. Buy a put that is one strike in the money sell a put with one strike out of the money. If the stock drops, preferably below the short strike, you’ll profit.
In the next article on I will go more in depth of low risk strategies vertical spreads