Investing in anything comes with risks. Options trading is a complicated form of investing, and as such, has unique risk factors to consider before jumping in. Learn how to reduce your risks in options trading.
Risks of Options Trading
The number one risk in options trading is the potential losses. If you’re a buyer, you are putting up a premium in hopes the price moves enough for you to profit with a purchase. If you’re a seller, you’re hoping the premium you collect will put you in the money before time runs out. Either way, you’re hoping you’ve gauged the stock properly.
You also have the liquidity to consider. Sometimes the stocks can only be sold in low quantities, so you must be sure you can sell off your stocks while the price is right. Liquidity, or the lack thereof, can drive up the cost as well, creating large spreads between the bid price and ask price.
Tips for Reducing Options Trading Risks
Understanding the market and doing your research are key factors in minimizing your risks. Below are four tips for applying your research to reduce those risks.
1. Use Options Spreads
One widely used method for minimizing risks is options spreads, which is basically creating one overall trading position by selling and buy the same number of options of the same asset with different expiration dates and strike prices.
A good example of this is by creating a bull call spread by buying in-the-money calls on a specific stock and then writing cheaper out-of-the-money calls for the same stock. By buying the calls, you stand to gain if the stock’s value increases. If the stock fails to rise in value, you could lose a portion or even all the money used in purchasing them. By writing the calls, you simultaneously limit the amount you can actually lose and control some of the initial costs.
2. Diversify Your Portfolio
By spreading your capital over a variety of different companies and market segments, you limit your exposure to losing all your capital if one company or segment falls short.
3. Get the Right Gamma
Understanding the gamma options is an excellent way to limit exposure to risk. Gamma is the effect on delta when the underlying stock moves up or down in price. When calling options, you want long gamma. When selling options, you want short gamma.
4. Use Option Orders
Option orders are an easy way to mitigate potential losses. One type is called a limit order, which allows you to set a minimum and maximum price for filling orders. This protects you from the potential losses of buying or selling at unfavorable prices you might encounter in standard options trading. You can also automate your order to exit at a specific price to either cut your losses or lock in profits.
Options trading is a common strategy for seasoned investors, but it does come with risks. Read these tips to limit your losses when you begin trading options.