How to Manage Risk Using Options

The consensus on options trading is that it is risky for the average investor. You’ll likely hear stories about people losing large sums of money in the options market.

This sentiment about options being risky can be warranted. However, it often comes from a lack of understanding about how the options markets work.

This article will help you learn instead how to actually manage risk — using options.

Compare the purchase of a stock at $50 per share vs. buying a six-month call options contract on that same stock.

Both transactions are for 100 shares. Further, suppose the premium on the options contract is $2.75 (x 100, which is $275). 

A $10 drop in the stock price represents a paper loss of $500 for the stock trade. However, no matter how far the stock drops, the risk for the options trade is always the same, $275.

Buyers of options never lose more than the premium paid.

If the stock is sold anytime after the drop in price, the stockholder faces a realized loss. Any loss greater than $275 would indicate that the risk of holding the stock is greater than the risk of holding the option. 

It’s also possible for the option to be closed out before expiration, which would reduce the overall cost of the option. This would lower the risk that much further.

Finding the right options contracts to lower risks takes practice. However, once options traders gain experience it is much easier to evaluate the profit-loss scenarios on these trades.

Hedging can lower risk

Another method of managing risks with options is to protect the purchase of a stock via hedging. Put options are contracts that increase as the price of the underlying asset decreases. Puts are perfect for hedging.

If an investor buys a stock at $50 per share and is worried about the risk exposure on this trade, he or she can purchase a put option.

It’s challenging to know which expiration date and strike price to choose. However, like the previous scenario, it becomes easier with experience. 

Beginning options traders can use the $50 put strike price (at the money in this example) as a good place to begin. This contract will cost less than in-the-money puts. It offers good protection for longer-term expirations.

Experienced traders may decide to trade shorter-term contracts. This tactic decreases the probability that the contracts will be profitable at expiration. However, the contracts are cheaper. Options trading is all about evaluating the probabilities of payouts and considering the tradeoffs.

Investors may decide to use hedging on riskier stocks and avoid hedging on safe stocks. As a portfolio grows, diversification will offer some protection from risk. Added protection from puts may not be as crucial. These constraints can be used to define a trading plan. 

Planning ahead

Following a plan is another method of reducing risks. By following the rules of the plan, traders will become more disciplined. Money management should also be used to contain the risks of portfolios.

The number of options contracts available in an options chain can confuse inexperienced traders. These traders should refrain from loading up on too many options in the beginning.

As they become more proficient at choosing the right expiration dates and strike prices, they can increase their use of options.

Hopefully, you have gained an appreciation for options and learned they could help lower risks when applying the right methods. Be prepared to make some mistakes, even if they cost some losses.

However, when you learn from these mistakes, you’ll avoid repeating them, and your options trading may help boost your returns.