6 Strategies for Reducing the Risk of Options Trading

by Dorano V. Professional PR since 2010

Even in times of relative economic turbulence, the options market has been able to enjoy significant rates of growth. Options trading is a strategy used by individuals who are often trying to control the risk of their overall portfolio, but many investors are discovering that trading options on their own has additional merits.

 

In essence, an option is a specific type of contract that allows the holder to buy or sell an underlying (commonly a stock) asset at a specific price at some future date. These are different than futures contracts because (in addition to variances regarding the underlying asset) they only present the holder with a specific right to buy or sell, rather than the obligation.

 

Options contracts can be very valuable because they may enable you to buy or sell an asset for a significantly different price than what the market is currently asking for. For example, you may have an options contract to buy an asset for $100. If the market price (also called the spot price) has risen to $120, you will be able to immediately exercise your call option and sell the asset for a profit. In this scenario, the profit that you made will equal $20 minus the price you paid for the options contract (which would likely be much less).

 

When options are exercised on a relatively large scale, it becomes quite easy to see how they can be profitable. However, as is the case with all financial assets involving a large degree of speculation, the options market is certainly not without its fair share of risks. In the scenario mentioned above, for example, if the price were to have dropped below $100, the contract itself would become fundamentally useless.

 

Fortunately, there are many actions you can take to help reduce the risk of holding an options contract. When bought and sold correctly, there is no reason that an options contract is necessarily riskier than any ordinary stock. Below, we will briefly discuss several popular options trading tutorials and how these strategies can be effectively utilized to reduce your exposure to risk.

 

1. Purchasing Put Options along with the Underlying Asset

While a call option gives you the right to buy at a predetermined price, a put option affords you the right to sell at a predetermined price. Because of this, if you want to be sure that you can sell an asset no matter what changes may occur in the future, the prospect of using put options as a form of insurance becomes very appealing.

 

If you purchase a put option combined with a long position in the underlying asset, then one of your positions will be profitable no matter what changes may occur. Suppose you purchase a stock for $100 along with a put option giving you the right to sell at $100 as well. If the price of the stock increases, your long position will become profitable (though the option becomes useless). If the stock price decreases, your option will become “in the money” and protect you from significant losses. Though there will be a small range where you can still lose money overall (hovering near $100), this is an excellent method for managing the risk of investing in very volatile stocks.

 

2. Purchase Call Options and also assume a Short Position

As you may have assumed from the example above, the exact same sort of risk management strategy can be applied in the other direction as well. If you have made a decision to short a stock, then you are generally hoping that the price of that stock will decrease in value over time. However, there will still exist the very real possibility that the price moves in a positive direction.

 

In this instance, purchasing an at-the-money call option will help you purchase a stock for less than it is worth and minimize the consequences of your otherwise damaging position. Though these strategies still present some degree of risk, they help limit the amount of money that you could possibly stand to lose while still allowing you the chance to earn major returns on your risk investments.

 

3. Purchasing Call and Put Options Simultaneously

Unsurprisingly, one of the most common risk management strategies in the options market is the act of purchasing call and put options simultaneously. You will have the option (pun intended) to purchase either at, above, or below the current market price (spot price). Depending on what future price points you believe are most likely to occur, you can easily adjust the strike prices of your options along with the portions of your portfolio that is committed to puts, calls, and the underlying assets.

 

4. Purchase Options with More Conservative Assets

When developing any risk-averse options trading strategies, it will be important to consider the other assets that currently make up your portfolio. As is the case with stocks and other financial instruments that are recognizably speculative, it is often a good idea to invest in some of your portfolio in assets that are almost guaranteed to be safe and reserve some of your portfolio for riskier investments (such as options). Balancing your options with CDs, government bonds, money market accounts, commercial paper, and other low-risk investments can help reduce the overall amount of wealth that you possibly stand to lose.

 

5. Diversify the Expiration Dates of Your Options

Unlike stocks, every options contract has a predetermined expiration date where your position will be revealed as either profitable or a bust. Like stocks, the value of any given option can significantly change over time. While many people focus on diversifying their put-to-call ratios, the value of “time diversification” is something that is often overlooked. Purchasing options with expiration dates occurring at different points in time can help you reduce the risk of short-term volatilities or other common market anomalies.

 

6. Study Historical Data

With some exceptions, options contracts can be purchased for seemingly every stock available on the market. However, some options contracts have historically not performed as well as others. If you are considering purchasing options tied to a specific stock—or even an index or other grouping of stocks—it may be well worth your time to research some historical patterns.

 

When looking at past performances, have call options or put options typically been more reliable? What has been the relationship between the values of these options and the prices of the underlying asset? Are these patterns something you can expect to continue? Though past performance will not always indicate how an option may perform in the future, studying these patterns may reveal an underlying issue you would have otherwise overlooked. There are also many different programs available that can help you analyze large amounts of patterns with ease.

 

Conclusion

The options market is one that has historically been quite valuable and has also created lucrative positions for people all over the world each day. However, due to their highly speculative nature, trading options is not without its fair share of risks. Developing a risk-averse and carefully crafted options trading strategy will help you create a more stable financial portfolio and put you in a position to succeed.

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Created on Jan 5th 2019 16:58. Viewed 413 times.

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