While many investors seek to maximize profits, it’s just as important to minimize risk. Big wins are great – but if you ask many seasoned traders, the pain of a big loss outweighs the pleasure of a big win. As such, we’re going to teach you how to manage risk for stock options. That way, you can keep your losses infrequent – and when they do occur, they won’t hurt you nearly as much.
In this quick article, we’re going to teach you what options trading risk management is – and why it is so important. Then, we’ll share a few of our favorite ways to manage risk as an options trader. By the time you finish reading this article, you’ll feel more confident as a trader – armed with the information and tools necessary to effectively manage risk along your journey. Let’s begin!
What Is Options Trading Risk Management?
First things first – what is options trading risk management? This is the practice of doing everything in your power to limit financial risk in your trading strategy. Risk management will vary from trader to trader. To effectively come up with a risk management plan, you’ll have to consider your unique risk tolerance. More aggressive traders can still manage risk – but the extent to which they do so will be lower than more conservative traders.
However, it is important to learn that managing risk does come with lower profit potential. That is because many of the tactics you’re going to employ involve hedging your trades and exercising options early to capture profits. While a more aggressive trader may take on more risk, they also may enjoy higher profits. Taking the time to develop a trading strategy that complements your risk tolerance is essential to get started with any investing style.
Why It’s So Important To Learn How To Manage Risk For Stock Options
Learning how to manage risk for stock options is perhaps more important than working to maximize profits. Why? Because consistently winning trades – no matter how small – leads to better overall returns than winning a few big trades and losing the rest.
Think about it like this: wouldn’t you enjoy a stress-free trading style that earns you a consistent 5-10% return on your capital each time you make a trade? Sure – you can’t beat the excitement of home runs. But those singles add up over time. Small, consistent returns are better than the occasional big return – with lots of losses sprinkled in. And the best part? With an effective risk management strategy, you can still earn incredible profits! We’ll explain how.
How To Manage Risk For Stock Options Trading: 5 Tips & Tricks
Ready to learn how to manage risk for stock options trading? There are quite a few ways you can keep your risk low while still enjoying high profits. From implementing proper analysis to hedging your bets, we’re going to share our favorite options risk management techniques for you below.
Take The Time To Learn Options Trading First!
We know you’re excited to get started with options trading. But if you don’t know what you’re doing, start by paper trading with options contracts. Paper trading is simulating real trading experiences with fake money. This allows you to get the hang of things and experience the highs and lows of trading before investing your hard-earned cash. Diving right into options trading without taking the time to gain experience and confidence is risky in itself. Our complete guides on how to trade stock options and when to exercise stock options are two important beginner resources.
Take Your Profits
When you have an options contract that is in the money early on, it can be tempting to keep waiting to realize additional profits. But we encourage you to exercise your options and take profits when you can. Say you purchase an options contract for company XYZ. The terms dictate that your strike price is $10 a share with an exercise date of 6 months from now for 100 shares. After a month the underlying stock price has risen to $14. You can exercise your option and realize an immediate profit of $400.
But wait – your technical analysis suggests that the price could continue trending upward. Should you hold out and squeeze out another 1-2%? Sure – but you’ll be kicking yourself if you miss the boat and the price reverses before you have a chance to exercise the option. Here is a better approach to trading options that allows you to take profits immediately while keeping the door open for future gains:
Let’s assume the aforementioned example is for a call option – and you can now buy those shares at the strike price of $10. You can then sell a portion of your shares at the market price of $14 for quick profits. Then, continue holding the rest of your shares and selling them off incrementally as the price continues to rise. If the price reverses while you are still holding the remaining 15% of your position? You are still in the money because you took profits all the way up to this point. This is called selling into strength, and it is one of the best ways to manage risk with any trading style – options included.
Cap Your Losses
Speaking of taking profits, we want to talk about the other side of the coin – capping your losses. Nobody wants to lose money on a trade. It is important to keep your losses small even if they are infrequent. If you win the majority of your trades, but your losses outweigh the wins, you’re still negative. By taking your medicine and accepting small losses every now and then, you can still maintain a positive ROI on your capital over the course of a week, a month, a year.
When it comes to trading options contracts, in particular, it is important to talk about time decay. Time decay is used to describe the depreciating value of your contract with each day that passes. Remember – your options contract is void after the exercise date. And as that exercise date looms closer and closer, your contract loses value from time decay. This is true whether you are in the money or out of the money.
Fortunately, your losses with an options contract are limited to just the premium you paid for the contract. Options contracts are typically pretty cheap, making them a great value investment for traders. If you don’t see yourself exercising your options contract, you can take one of two steps: letting it expire or selling the contract back on the stock market. While you may not get the full value you paid for the contract, speculative investors may purchase your contract and help you cover some losses.
Diversify Your Trades
If you’ve spent any time learning about investing, you have heard about diversification. It’s true – putting all your eggs in one basket is a sure-fire way to leave empty-handed. So when seeking out options contracts to trade, be sure to diversify your portfolio by looking at different industries, different companies, and different types of options contracts.
This is also a good time for us to talk about position size. The last thing you want to do is blow up your trading account and lose everything. So, limit your position sizes to a modest percentage of your total working capital. It can be really tempting to go all-in on what appears to be an easy win – but avoid putting more than 20% of your total capital into any contract. Not only does this limit risk, but it also ensures you have capital on hand to dedicate to other opportunities that come up.
Invest In A Quality Stock Forecasting Software
The best way to manage risk with options trading – or any investment style, for that matter – is to just win every trade you make. Simple enough, right? Unfortunately, this is unrealistic. But, you can set yourself up for the greatest chance of success by investing in a reliable, tried and true stock forecasting software. What exactly will this do to help you manage risk, though?
Well, you’ll be able to purchase contracts with more confidence based on the insights you gain through the software. VectorVest is one such software – and inside the dashboard, you can pull up pre-built searches that uncover opportunities for you on autopilot. Better yet, you can eliminate any uncertainty as to when you should buy your contract or exercise your options. How? VectorVest provides a clear buy, sell, or hold recommendation for any given stock. You can get a sneak peek of what this looks like in practice with a free stock analysis.
Simply put, investing with the help of a stock forecasting software will help you win more trades and manage risk more effectively. Simplified indicators help you assess opportunities and get in/out at the perfect time. Trust us – you’ll never go back to trading options the old way.
Final Thoughts On Options Trading Risk Management
Now that you know how to manage risk for stock options trading, you are well on your way to keeping your losses small and infrequent. If you want to gain even more confidence as a trader, invest in yourself by going through the Options Paycheck Experience. This crash course in options trading will help you generate consistent income from options spreads – no matter your experience level. The value that has been packed into this one-of-a-kind program is unparalleled. You won’t regret taking the leap and learning from the experts!