Manage Risk in Options Trading
The market is hitting new multi-years highs and investors are flocking back in. All the new found euphoria represents a danger signal to me.
Too say it otherwise, the tendency is to accept too much risk precisely at the wrong time in the market. No one knows when the exact top in the market will be reached. Traders thinks that we are probably much nearer at markets high than we are to the bottom. Therefore it’s more important than ever before to manage your portfolio for risk properly.
When you trade options it is less important to look at the returns you are getting. In fact it is fairly easy to make good returns by selling options. You will receive option premium. Time is guaranteed to pass and theta decay will make you money. The real secret is making many profitable trades. Many profitable trades will make big profits.
Manage Risk by Strategy selection.
Important to option trading success is to know whether a rise or fall in volatility will help or hurt your position. The right strategy selection is important. Some strategies should only be used when volatility is low, others only when volatility is high.
Controlling risk is a paramount concern for any option trader. In a bull market we sell one strike out of the money puts very often. You will receive a option premium because you take on a low probability risk for larger loss. When presented with the likelihood of many small wins and a few losses the best thing is to maintain many small positions of roughly equal size. The basic idea is to cover the losses a few winners. That way most months are winning months. More importantly, you avoid the possibility that a single large loss in a big position can wipe you out.
Manage Risk selecting defined Risk
Traders have to think decide whether they want to apply undefined strategies or risk less capital by using defined risk strategies. Of course when you trade using defined risks strategies you will earn smaller profits. When you take more risk it will come with bigger profits. The amount of risk you take is determined at order entry. With undefined risk trades you do not know what whether you win or how big your lose will be. With defind risk trade you lower your risk.
The position size is essentially the amount of money you put into the market – in other words the amount of risk that you take with the trade. The larger the position size, the more money you will make if the trade wins. However, this also means you can lose more money. This is why using the correct position size is so important, because you can keep within the correct limits of money management and protect your capital from losing trades.
Manage Risk by equal capital
Traders want to be in the game for ever. They don’t want to take to much risk that can hurt them. Proper Capital Allocation is very important. I would never put to much risk on any given trade. If it goes south I do not want to loss a big portion of my portfolio. A professional trader never risk more than 3% of his trading account on any single trade. Starters may start with 5% risk. They need to be aggressive in closing managing their trade as well.
Consistency is one of the most important traits of traders — consistency in the execution of their trading plan from entry to position sizing to exiting.