Options Trading and Risk

Although options are one of the most used financial instruments nowadays, they are complex and can be extremely risky. On the other hand, option trading strategies can make investing safer. Options are the most versatile trading instrument available and are wonderful and flexible tools that can be used by stock investors to reduce risk and enhance returns.

What are the risks with Option trading?

  • Greed. This is the single biggest risk, and it is entirely human in origin and not intrinsically attached to options trading. Many people start trading options because they see the huge profit potential and hope to "get rich quick". Unfortunately the emotions of greed cause people to abandon a trading plan, make snap decisions, and start gambling.
  • Loss of Capital. When you have purchased stocks, a bad turn in the market can cost you a few percent, which in most cases (except when the market really crashes) is less than 10%. With options trading, even though you are trading much smaller amounts of money, you can lose 100% of the amount you put into the trade, if the market goes against you.
  • Trading on margin. Selling options involves providing a margin in case your trade turns into a loser. Many times, this margin requirement (set by your broker) is significantly less than the full cost that you would incur if your trade bombs (which can happen quite quickly). This can leave you in debt to your broker.

How to guard against risk in options trading

  • Trading Plan - have one that you have researched, refined and practised using paper trading. When paper trading, make sure that you have traded long enough so that you get to experience some trades going against you - there is nothing better than this to help you learn to read the danger. Stick to your trading plan!
  • Correct technical analysis. Many options traders fail through over analysis. The rules for technical analysis for options are very different from those on stocks, and indeed, each options trading strategy has its own "suite" of analysis needs. Once you have decided on a strategy, find out exactly what type of analysis is required, and stick to that.
  • Capital allocation. Don't over allocate. Most option traders recommend that you do not commit more than 2% of your capital to any given trade. This means that you can absorb several severe losses, and still have some trading power. If you are selling options, always leave about 20% of your capital available so that you have the ability to "buy" yourself out of a bad trade before it crosses the line and becomes a huge margin responsibility.

Options trading provides so many advantages that a smart investor would be unwise to ignore the potential. At the most conservative level, they provide a means of reducing the cost of your stock, or of hedging against loss. They can be a source of safe, regular income, or they can provide a significant boost to your investment strategy. Before getting started, learn about the different strategies, make sure you apply the correct technical analysis, and don't be driven by greed!

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  • On this page are some thoughts on options trading and risk. The popular idea is that options trading is risky, but actually it can be safer than trading stocks. It gives you diversity of investment strategies, and each strategy has a different risk profile. You can choose the one that best suits your trading experience.