Effective risk management is vital for everyone who decides to participate in trading the financial markets. It helps traders limit the potential for loss and manage uncertainty so that they can stay informed and make confident trading decisions. However, for many, it remains unclear what risk management consists of and how they should go about implementing strategies.
In this article, we will define what risk management is. We will go through some common risks that options traders face, as well as some popular risk management techniques that can be used specifically for options trading. If you are keen to learn more about this topic, read on.
What is risk management?
In trading, risk management refers to the processes, strategies, and techniques traders use to manage their risk exposure. Risk comes in many forms, at different stages of the trading process, with the biggest one being market risk. The goal of risk management is to minimise potential losses while maximising potential gains.
Traders participate in risk management by identifying and assessing the levels of risk associated with a trade. They then determine an appropriate level of risk tolerance or strategy, and they implement their plan to mitigate risk.
Common risk management strategies include using stop-loss orders, diversifying a portfolio, setting realistic expectations, doing sufficient market research, and regularly monitoring open positions to make sure they remain within acceptable levels of risk. There are also strategies focused on options trading, related to contract strike prices, time decay, and the purchase of multiple contracts to construct a spread. In this article, we will examine some of them.
As mentioned, to devise the appropriate risk management strategy, we must first know more about the risks of options trading.
Risks of options trading
Options trading is a form of derivative trading, where traders speculate on the price movement of an underlying asset and aim to make a profit from the asset’s fluctuating prices in the market. Some traders consider it a more complex form of investing, compared to the traditional buying and selling of assets. This is because traders must learn what options contracts are and how they work, on top of monitoring the financial markets on which they speculate. Some common risks of options trading include:
Market risk
The most common risk of options trading is market risk. This comes from the unpredictability of fluctuating markets. Options traders speculate on price movements of underlying assets, which may have the possibility of falling.
Some factors that affect market risk are interest rates, inflation, currency exchange rates, geopolitical events, and the overall health of the economy. Depending on the exact instrument you speculate on, there may be more factors that contribute to their market performance.
Volatility risk
There is also the risk of volatility – which is the uncertainty of an option’s price movement. This can increase or decrease the value of the option contract and it can have a significant impact on the potential outcome of the trade. High volatility in the underlying asset can cause the price of options to fluctuate rapidly and unpredictably, increasing the risk of loss for options traders.
Time decay risk
One of the most important things traders must know when trading options is that options contracts have expiry dates. In other words, they have a limited lifespan, and generally, their value decreases as time passes. This is known as time decay, or theta risk, and it can erode the value of their positions over time.
Time decay risk is particularly relevant for short-term traders who prefer to buy options contracts with short expiry dates. To manage this risk, therefore, traders can sell their options before they expire or simply purchase contracts with longer expiry dates.
Strike price risk
In an options contract, the strike price is the price at which the trader can execute the option. Traders predetermine the strike price when they purchase their option, along with the contract’s expiry date. If a strike price is too high or too low over time, it can be difficult for the asset price to match or exceed it, which can potentially increase the chances of losses.
Risk management strategies in options trading
If you are new to managing your risk when trading options, you can get up to speed quickly with this article. Below, we explore five of the most common risk management strategies for different scenarios. Whichever one you use will depend on the circumstances and your preference.
Portfolio diversification
One of the most common risk management strategies is portfolio diversification. This is when a trader splits their investment funds across several products across markets. By doing so, they spread their risk across different assets. Some traders also split their risk across markets that have little to no correlation with their other investments, so that if one market dips unexpectedly, their other investments can remain relatively unaffected.
Hedging
Another common risk management strategy is hedging. This is when a trader opens a position in the opposite direction of an existing trade to counter the effects of adverse market conditions. Hedging is an effective method for traders who do not want to close out their positions and would rather ride out market fluctuations in the short-term.
Stop loss orders
Another way to mitigate risks is to use stop losses. A stop loss order is an automatic command that helps traders sell off an option if the price of an underlying asset falls below or above a certain level. It is a good way to manage risk effortlessly for traders who do not have a lot of time to sit around closely monitoring markets. It also ensures that traders are quick enough in selling off their options contracts when prices begin to become undesirable.
Protective puts
A protective put is essentially a put option that a trader buys to protect against potential losses. Traders purchase a protective put option when they already have an existing position open. For example, a trader who owns stocks issued by Company XYZ foresees its price depreciating. To offset losses, they may purchase a put option of the same amount, on the stock. The stock option then helps to protect against potential losses on the first position.
Options spreads
Intermediate to advanced trader may also use options spreads to mitigate risks. This is when they purchase multiple options contracts with different strike prices, and they combine these contracts to build a more complex spread. Some popular options spreads include the butterfly pattern, the long straddle, and the iron condor. However, this is a more complicated way of mitigating risks, and it can be confusing for rookie traders who are just finding their footing.
The bottom line
Risk management is essential in trading, particularly in options trading due to its more complex nature. Having the right strategies in place not only helps traders mitigate the potential for loss, but they also help traders make more informed decisions on the daily. When you are devising your risk management plan, you should set clear risk tolerance levels, investment goals, and trading timeframes. You should also keep an eye on the markets and make sure you can react quickly should your predicted circumstances change. Finally, the most important thing in risk management is consistency and discipline, which you will need to help you stay on track.
