Home > Blogs > Options Trading: Keeping Risk Levels in Mind

Options Trading: Keeping Risk Levels in Mind

By  Feb 4, 2010

Topics: Finance & Investing

It’s easy to get lost in the complexity of options trades and even to enter trades that are entirely inappropriate. Why? The appeal of a complex trade may easily override your risk tolerance, leading you unintentionally into high-risk ventures that are not good fits for you.

This is a common trap for options traders. The experienced trader knows about the allure of the “sure thing” trade. You can become convinced that the strategy you have developed on paper simply can’t lose. you may also tell yourself that the strategy is your own invention, and you will be amazed that no one else has ever thought about it.

The fact, though, is that just about every twist and turn possible with options has been tried before and in many variations. Another fact worth remembering: There are no “sure things” and even that foolproof money-making idea is not always going to come through.

 Some of the important considerations that are easy to overlook or ignore:

            1. Combination strategies (spreads and straddles) involving both a short and a long side could be higher-risk than you recognize at first. This is especially true if the long side, which covers the short, 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.

             2. Some “foolproof” strategies are derailed through the unexpected early exercise. Any time you include a short position in your strategy, this is a possibility. As part of your analysis, be sure you think about all of the “worst case” scenarios, including finding yourself needing to buy or sell 100 shares of the underlying.

            3. A strategy can include a margin surprise. Based on price movement in the underlying or the number of open contracts you create, you could be hit with a margin call just to keep your broker’s risks in check and to stay in compliance with Regulation T levels. 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 specific goals for yourself and to stay with them. The greatest risk for option trades is the “greed factor.” Your goals should include price points where you will take profits or cut losses. Resist the temptation to turn a decent profit into a killing, because you could end up losing the whole position by waiting too long.

Some of those complex options transactions are appropriate, of course. But the strategy you pick should conform to your risk tolerance and meet the goal and purpose for entering options trades in the first place. With about 75% of all option contracts expiring worthless, you are most likely to succeed when you identify your reasons for using options, and resisting the temptation to go beyond the borders you set for yourself.