Here are five ways to effectively manage risk as an option trader:
- The first step in managing risk as an option trader is position sizing. When buying options the amount of capital you spend buying an option contract long is the most you can lose if your option expires worthless before expiration. The best way to avoid the risk of ruin when trading options is to never put on a position size greater than 1% to 2% of your total trading capital. If you have a $50,000 option trading account your maximum option trade should be $500.
- When selling option contracts to open your risk can be theoretically unlimited unless you buy a farther out option as a hedge. Using fix loss option plays is important so you cap the amount of your losses if a strong trend moves against your short option. You should buy your hedge at the location of price you want to cap losses at.
- If you sell a covered call your risk is in the stock. You can set a stop loss for your stock position where you will cut your losses short and buy to cover your short call.
- If you sell a married put your risk is in the short stock. You can set a stop loss for your short stock position where you will cut your losses short and buy to cover your short stock and buy to close your short put option.
- Do not put on option plays with open risk or undefined risk. It is very dangerous to expose yourself to uncapped and unlimited risk selling options short, the odds are that eventually you will be ruined on one outsized move. Always have an exit strategy when you sell option contracts. Option hedges are insurance that will pay for their self over the long term.
Mice see the cheese but not the trap. Option traders see the rewards but not the risk.