Options Risk Management – How Do I Manage My Risk in Options Trading?

Like all forms of investment, there is risk associated with trading options too. But this risk can be managed with some basic knowledge.

Lets examine the various risks associated with options:

1) Price Uncertainty –

No one can say with absolute certainty where the price of a stock is headed. You wont know whether the Johnson & Johnson (JNJ) is going to be higher tomorrow, in a week or in a month from today. This uncertainty regarding price poses one risk.

2) Timing Risk-

Options, like bonds and futures, have an expiration date. The holder of the contract has to decide whether to exercise the option to buy or sell the underlying asset on or before that date. Getting the timing right is imperative because the amount of profit or loss is dependent on when that option is exercised.

3) Volatility Risk-

In addition to the price and timing risks, there is another risk – volatility. This is a measure of much the price of an option can vary during a certain period of time. During periods of high volatility it is very possible to see rapid price movements in the underlying asset which affects the strike price of the option.

You must be wondering – with all these risks, how am I supposed to make the right choice? The irony is that an option itself is a form of risk management. The leverage you get from options helps to manage price risk by protecting your principle. Lets have a look at an example:

Suppose you want to buy 100 shares of Apple (AAPL). At the current market price of $100, this would cost you $10,000 (not including broker commissions). Thats a lot of money for novice investors. But, using options you could control 100 shares of Apple by buying a single options contract. Depending on the strike price you would be able to control the 100 shares for less than a fraction of the cost of owning the shares. If you bought the 100 shares instead, you could stand to lose a larger sum of money if the stock were to decline significantly. However, if you used options you would only stand to lose the option premium.

Another way to manage your risk would be to identify the various risks and quantifying them i.e. measuring the delta, theta, vega among others.

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