Know Your Risks When Trading Options

May 26, 2018

Options are a leveraged instrument, and if you’re not careful, it’s easy to find yourself exposed to more risk than what you’re comfortable with. A subscriber to All Star Options pinged me this week with some questions and I thought our discussion might be fruitful to everyone…

Subscriber:

The idea of keeping a good risk to reward ratio is great for stocks. But for options, sometimes  if the risk is smaller than the reward, the option doesn’t reflect that. The option price falls a lot more (in percentage terms), even if the stop was quite tight compare to the target price. So you end up losing just as much as you would have made had you hit your target first despite keeping a good risk to reward on the underlying. How to adjust for that in options? 

Sean: 

Managing risk in options trades ultimately comes down to position sizing. You need to have a clear concept of how much you can lose, and then size your position such that if that loss is suffered, the damage is at an acceptable limit.

This is relatively easy with defined risk spreads and long options. You know your max loss. It’s a little trickier with naked short options (I always say err on the smaller side when choosing trade size).

It’s important to note that you shouldn’t be comparing your win or loss percentage gain/loss against the underlying’s move. They really are apples and oranges.  A stock could move +10% and your option might increase 50% or only 3%, depending on the structure of the trade, time to expiration, change in volatility, etc.

Subscriber:

If the best way to manage risk in options with straight buying calls or buying puts is to manage position size, then which is the best approach to take:

  • Buying out of the money options with a medium time to expiry, where if it hits the strike price and beyond you could double your money or lose everything (similar to a double or nothing situation). Or,
  • Buy expensive deep-in-the-money options with plenty of time till expiry, where the percentage movements won’t be as extreme as described above, but the % movement would still be a bit more active than just trading on the underlying stock?

Sean: 

Unfortunately, this is a question I can’t answer for you. This is an area where you have to determine what you’re comfortable with?

Do you prefer a lower probability of success coupled with a higher potential payout? Or, do you prefer a position that will more closely match the performance of the underlying tick-by-tick for less than the cost of outright stock ownership?

It really depends on which trade-offs you’re willing to make.

My personal preference when trading straight naked long calls or puts is to purchase 25 delta OTM options. They seem to usually offer the sweet spot between potential reward vs cost of participation, in my opinion.

Check out the options module in All Star Charts EDU for more on my Best Practices for trading options.

And if you’d like to be a Founding Member of All Star Options where we share ways to trade JC’s best ideas derived by expert technical analysis using options and spreads, then take advantage our low introductory pricing now.

~ @chicagosean