Traders can easily become so focused on the details and rules of the trade, that they overlook the true market risks of a particular strategy. The appeal and elegance of options trades can cloud the serious issue of risk and how it affects the success of a trading and investing program.
Options traders need to remain aware of how risk defines the value of the trade. The “sure thing” of a covered call of other “safe” strategy might not be as sure as it looks at first glance.
When it comes to options trading, a little knowledge really is a dangerous thing. The truly experienced trader is the one who has made all of the mistakes and knows how to avoid them in the future.
Remember these guidelines concerning risk when you are thinking of entering any options position:
1. Any advanced strategy, such as spreads and straddles, that involve both a short and a long side could be higher-risk than you think at first glance. This is most important if the long position, which covers the short position, expires before the short. Or if you close out the long side at a profit, the short side remains exposed. This is where you can be taken by surprise when the short is exercised; and remember, exercise does not have to happen on the last trading day. It can happen at any time that the short option is in the money.
2. Many strategies that seem obviously safe and sure can be destroyed through early exercise. Any time your position involves a short option, this is possible. Your worst case planning should always begin with asking yourself what happens if the short option is exercised. Monitor the status of short positions and have a plan for rolling forward as tjhey approach the money.
3. You might get a margin surprise. If the price of the underlying moves substantially or the number of open contracts changes or moves in the money, you could be hit with a margin call to keep in compliance. If a strategy calls for you to increase open positions based on later price movement, look into the margin requirements that come along with the strategy.
4. Remember to set goals and stay with them. The greatest risk for option trades is greed. Include price points where you plan to take profits or cut losses. Resist the temptation to turn a decent profit into a killing, because you could end up losing the entire profit.
The strategy you use should be a good match to your risk tolerance and meet your goals for entering options trades. You are most likely to succeed when you identify your reasons for using options, and resist the temptation to go beyond the limits you set for yourself.
Michael C. Thomsett is an instructor with the New York Institute of Finance. He teaches three options courses: “Swing Trading with Options,” “The Amazing World of Options,” and “Synthetic Options Strategies.” He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.