Risk Management in Options trading
Risk Management is the main component of any successful Option trading strategy. To profit from trading we must incur the risk of losses. The bottom line is that without proper management of risk there will eventually come a day when the trader can no longer execute a position because of the catastrophic trading losses that are a result from continuous unmanaged risk.
Planning Your Trades. As Chinese military general Sun Tzu’s famously said: “Every battle is won before it is fought.” The phrase implies that planning and strategy – not the battles – win wars. Similarly, successful traders commonly quote the phrase: “Plan the trade and trade the plan.” Just like in war, planning ahead can often mean the difference between success and failure.
Good capital management can be viewed as risking as little trading capital as necessary so as to maximize profit. This is much easier said than done. Poor risk management can negate all gains and lead to account blowup.
Risk management should be viewed in three separate but related arenas:
- Trade risk
- Strategy risk
- Portfolio risk
Trade risk can be defined as the possibility of financial loss from an individual market position. Entering trades with the right kind of probability of profit will set you up for a reasonable amount of trades which are going to be won.
When you sell or buy options you collect option premium. The amount of premium is accordingly the risk you take. You can vary your risk to sell options nearer of further out of the money. And of course when you keep your position size small you don’t take on much risk.
A key principle of risk management in options trading is that of position sizing. Sizing correctly allows investors to trade more positions that are diversified across many products and strategies. Following this one principle alone greatly reduces the probability of a large loss in any one position. You better trade small and trade often.
Strategy risk is the amount of capital put at risk while using a particular trading strategy so as to be able to realize its return potential. Put differently, every strategy has some inherent risk, and even the best can fail on any particular trade. Strategy risk highlights the importance of recording each trade. If the trader accurately tracks each trade, he or she can go back and evaluate which trade setups work the best and also those that don’t work out as well. The use of undefined or defined risk strategies will also determine how much capital is at risk.
Finally, portfolio risk is the amount of capital put at risk while using a particular trading strategy with multiple options. As a Option trader we have a myriad of currency pairs we can trade and often newbies believe that in order to make profits they must be trading every possible currency pair. As important as it is to recognize which trading strategies are the most successful, recognizing which currency pairs are the most profitable can allow a trader to increase the profitability and limit the risk of the account.
Watch the video on Risk Management in Options trading
Today’s show focuses on portfolio management and how to best examine and optimize your trading account! Using a question from a viewer, Tom and Case break down the many moving parts of portfolio adjustment. Tom stresses first looking at individual positions and determine what needs to be adjusted, rolled, or closed to increase probability of profit. After that point, Case and Tom go on to analyze the intricacies of doing that on an overall portfolio level– not analyzing individual strikes, but rather entire positions and underlyings overall and how they fit into the delta risk and market behavior currently taking place!
When selling options and buying them you like to get enough premium but you don’t want to have a lot of risk.
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