People come and go. Return On Capital vs. Hopefully this article helps someone manage risk and not get taken to the cleaners. Proper risk management planning may seem too old-school for some people, but the reality is that risk management is the 1 factor for options trading success. It sounds too simple to be true, but when it comes to stocks or options, one of the keys to making money over the long-term is doing all that you can to avoid losing money over the short-term. Every investment involves some degree of risk, which can be very close to zero in the case of a U.
Synthetic Options: both futures and options may be used simultaneously to create a synthetic options a. Synthetic Long Call = long futures + long put on the same underlying. Like a long call, prices can increase without restriction. The .
DEFINITION of 'Risk Management'
While it's difficult to completely remove the emotion involved with options trading, you really want to be as focused as possible on what you are doing and why. Once emotion takes over, you potentially start to lose your focus and are liable to behave irrationally.
If you follow your plan, and stick to using your investment capital then you should stand a much better chance of keeping your emotions under control. Equally, you should really adhere to the levels of risk that you outline in your plan.
If you prefer to make low risk trades, then there really is no reason why you should start exposing yourself to higher levels of risk. It's often tempting to do this, perhaps because you have made a few losses and you want to try and fix them, or maybe you have done well with some low risk trades and want to start increasing your profits at a faster rate. However, if you planned to make low risk trades then you obviously did so for a reason, and there is no point in taking yourself out of your comfort zone because of the same emotional reasons mentioned above.
Below, you will find information on some of the techniques that can be used to manage risk when trading options. Options spreads are important and powerful tools in options trading. An options spread is basically when you combine more than one position on options contracts based on the same underlying security to effectively create one overall trading position. For example, if you bought in the money calls on a specific stock and then wrote cheaper out of the money calls on the same stock, then you would have created a spread known as a bull call spread.
Buying the calls means you stand to gain if the underlying stock goes up in value, but you would lose some or all of the money spent to buy them if the price of the stock failed to go up. By writing calls on the same stock you would be able to control some of the initial costs and therefore reduce the maximum amount of money you could lose.
All options trading strategies involve the use of spreads, and these spreads represent a very useful way to manage risk. You can use them to reduce the upfront costs of entering a position and to minimize how much money you stand to lose, as with the bull call spread example given above. This means that you potentially reduce the profits you would make, but it reduces the overall risk.
Spreads can also be used to reduce the risks involved when entering a short position. For example, if you wrote in the money puts on a stock then you would receive an upfront payment for writing those options, but you would be exposed to potential losses if the stock declined in value.
If you also bought cheaper out of money puts, then you would have to spend some of your upfront payment, but you would cap any potential losses that a decline in the stock would cause. This particular type of spread is known as a bull put spread. As you can see from both these examples, it's possible to enter positions where you still stand to gain if the price moves the right way for you, but you can strictly limit any losses you might incur if the price moves against you.
This is why spreads are so widely used by options traders; they are excellent devices for risk management. There is a large range of spreads that can be used to take advantage of pretty much any market condition. In our section on Options Trading Strategies , we have provided a list of all options spreads and details on how and when they can be used.
You may want to refer to this section when you are planning your options trades. Diversification is a risk management technique that is typically used by investors that are building a portfolio of stocks by using a buy and hold strategy.
The basic principle of diversification for such investors is that spreading investments over different companies and sectors creates a balanced portfolio rather than having too much money tied up in one particular company or sector. A diversified portfolio is generally considered to be less exposed to risk than a portfolio that is made up largely of one specific type of investment. When it comes to options, diversification isn't important in quite the same way; however it does still have its uses and you can actually diversify in a number of different ways.
You can diversify by using a selection of different strategies, by trading options that are based on a range of underlying securities, and by trading different types of options. Essentially, the idea of using diversification is that you stand to make profits in a number of ways and you aren't entirely reliant on one particular outcome for all your trades to be successful.
A relatively simple way to manage risk is to utilize the range of different orders that you can place. In addition to the four main order types that you use to open and close positions, there are a number of additional orders that you can place, and many of these can help you with risk management. That deviation can be positive or negative, and it relates to the idea of "no pain, no gain" to achieve higher returns, in the long run, you have to accept more short-term risk, in the shape of volatility.
How much volatility depends on your risk tolerance, which is an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.
Investors use a variety of tactics to ascertain risk. One of the most commonly used absolute risk metrics is standard deviation , a statistical measure of dispersion around a central tendency. You look at the average return of an investment and then find its average standard deviation over the same time period.
This helps investors evaluate risk numerically. If they believe that they can tolerate the risk, financially and emotionally, they invest. This number reveals what happened for the whole period, but it does not say what happened along the way. This is the difference between the average return and the real return at most given points throughout the year period. If he can afford the loss, he invests. While that information may be helpful, it does not fully address an investor's risk concerns.
The field of behavioral finance has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory , an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in , investors exhibit loss aversion: For more on this, read Behavioral Finance: Often, what investors really want to know is not just how much an asset deviates from its expected outcome, but how bad things look way down on the left-hand tail of the distribution curve.
Value at risk VAR attempts to provide an answer to this question. The idea behind VAR is to quantify how bad a loss on an investment could be with a given level of confidence over a defined period. For example, the following statement would be an example of VAR: Spectacular debacles like that of the hedge fund Long-Term Capital Management in remind us that so-called "outlier events" may occur. Another risk measure oriented to behavioral tendencies is drawdown , which refers to any period during which an asset's return is negative relative to a previous high mark.
In measuring drawdown, we attempt to address three things: One measure for this is beta known as "market risk" , based on the statistical property of covariance.
A beta greater than 1 indicates more risk than the market and vice versa. Beta helps us to understand the concepts of passive and active risk. The returns are cash-adjusted, so the point at which the x and y-axes intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us to quantify the passive risk beta and the active risk alpha. The gradient of the line is its beta. For example, a gradient of 1.
A manager employing a passive management strategy can attempt to increase the portfolio return by taking on more market risk i.
plus quick adjustments you can make to losing positions.
This is an article about risk management and how to have fun yet increase your safety by modifying your risk profile. How to avoid traps. Options: A way to change your risk profile. Risk & Money Management. Correctly managing your capital and risk exposure is essential when trading options. While risk is essentially unavoidable with any form of investment, your exposure to risk doesn't have to be a problem. Update On Options Risk Management August 22nd, Weekend Market Update (Stocks Suffer Worst One Day (And Weekly) Decline Of ) August 22nd, 10 Stocks With Unusual Options Activity (JWN, .