Options trading is exhilarating, complex, and profitable with the right strategies. However, it also comes with risks that other investment classes, like stocks, do not. If you are an options trader or are thinking of becoming one, you should always have risk management plans and strategies. Doing so minimizes potential losses and gives you peace of mind knowing your investments are not at an incredibly high risk. Today, we will look at several risk management strategies for options traders.
Learn Before Trading
While it can seem simple enough, enter a contract to buy if you think the price will go up and one to sell if you think the price will go down, option trading is a lot more nuanced than that. There is so much to know and learn, and you should ideally understand it in as much depth as possible before getting started.
You can start by reading relevant books like James Cordier’s Complete Guide To Option Selling. This options selling book tells you everything you need to know, including when to buy and sell, how to take advantage of different seasons, manage risks, and the mistakes to avoid, especially if you are a beginner.
You should also listen to investment podcasts that talk about options trading. Even though they might not give you actionable insights, they might be a source of crucial information that can make you a better trader.
Next, learn about the different tools trading or broker platforms use. Many give you a demo account with a specific balance so you can make some trades and familiarize yourself with the whole process.
Take a Profit Ads Soon As Possible
One of the easiest ways to protect yourself and your investment in any trade, not just options, is taking a profit as soon as possible. While it sounds great in theory, many traders do not do this, and there are several reasons why.
First, their indicators show them that they can still make more money. They reason that leaving the profit as part of the trade will lead to a bigger profit. However, they forget that it can also lead to a much bigger loss if there is a sudden downswing. Remember, the value of underlying assets can fluctuate rapidly, leading to a loss.
Second, they see a small decrease in the profit and want to recoup it when prices bounce back. This does not always happen, and it can lead to losses if the contract reaches the expiry date or execution time before they have executed it.
The key takeaway is that no one can predict what the market will do in the future, even in the next few seconds. It is, therefore, best to make a profit as soon as you can instead of chasing a larger one and putting it all at risk.
Choose Strategies That Align With Your Risk
Different strategies have different levels of risk and returns, and they appeal to different types of traders. The three main types of options traders are day traders, scalpers, and swing traders. Scalpers take on the most risk because they initiate numerous trades every few seconds or minutes to take advantage of rapid price fluctuations.
Day traders take on less risk and buy option contracts during the day and sell them at the end of the trading session. They hope to enter into favorable positions they can capitalize on before the day closes.
Swing traders take on less risk than day traders because their contracts last for several months. This means they have a lot more time to execute their trades, even with the pressure of time decay.
Knowing how much risk you can take on and how involved you want to be with your trades will help you know which type of trader you are and help you adjust your risk accordingly.
Cover Your Calls
Covering your calls is mainly used by advanced traders, but you can use it as a beginner or if you have some experience. To cover a call, you must already own the shares that are the underlying asset for the call options you sell.
Let’s say you own 300 shares of a company’s stocks. You can write call options for all of them and generate an income selling those calls. You do this by keeping the premiums buyers pay if they do not execute their contract. This is one of the most common ways for traders to make money with options trading.
If the buyer chooses to execute a contract, you transfer the shares to them since you already own them. You make money on the premiums and the increased price of the shares you already own.
Even though you cannot expect to make massive profits doing this, you still make some money while also learning how to trade options.
Avoid Low Liquidity Assets
You must be able to sell the underlying asset of a call contract if you execute it. You do this through a put option or other means. Unfortunately, some assets are not liquid enough or have enough market interest or activity to justify buying contracts on them.
If you end up with them, you might have no one to buy them or might have to sell them at a significant loss.
For this reason, you should always do thorough research to ensure you have smart entry and exit points. You should also check your strike price to ensure it is easy to sell the assets. Keep in mind that every asset has a different depth, the deviation at which you can set the strike price for call or put options.
Be Aware of Time Decay
Time decay occurs as the expiry approaches. It leads to decreasing premiums, meaning you can make less on premiums the longer you hold onto a contract, so it is better to execute it as early as possible, preferably when you hit your desired profit levels.
Every investment is inherently risky, but options carry a higher risk. That said, traders can use various strategies to reduce the likelihood of losing their money, whether that is learning how options work and how to leverage the market or knowing when to enter into and execute different contracts.