How to Reduce Risk in Options Trading: 10 Tips

Options trading has become very popular among traders because of its profit potential. But there is another side of options trading that often gets ignored: loss. This is one of the trickiest parts of options trading because factors such as leverage, premium decay, volatility, etc. need to be evaluated before executing an option trade.

In today’s blog post, we will give you an overview of the practical ways to reduce risks in options trading. 

What is Option Trading?

Option trading is a type of derivative trading in which a trader buys and sells option contracts based on underlying assets, including stocks, indices, commodities, etc. An option buyer gives them a right but not the obligation to buy or sell the underlying asset at a predetermined price, often known as the strike price, on or before a specific expiry date.

Types of Options

There are two types of options:

1. Call Option: This option is generally used when a trader expects the price of the underlying asset to rise.
2. Put Option: A put option is used when the trader expects the price of the underlying asset to fall.

Moneyness of the Option

There are three types of moneyness in options:

• In-The-Money: This is an option that has an intrinsic value, and if anyone has to exercise the option at its strike price, it would have a positive value based on the current market price of the underlying asset.
• At-The-Money: It refers to the option strike price which is the same as the current market price of the underlying asset. This option does not have any intrinsic value.
• Out-of-the-Money: An out-of-the-money option does not have any intrinsic value; it is because the underlying asset has not moved enough in the expected direction. This option looks attractive to the new investor because of its low price but it carries high risk.

Factors That Make Option Trading Risky

The key factors that make option trading risky are as follows:

1. Leverage: Leverage allows a trader to take large market exposure with a limited amount of capital. This can increase the return potential; however, it can also magnify the loss similarly.
2. Time Decay: Options have a fixed expiry date, and as the date approaches, the time value of the option decreases, which is unfavourable for option traders.
3. Volatility: Option prices are very sensitive to market volatility. Any significant fall in market volatility can reduce the option premium significantly and vice versa.
4. Unlimited Loss: Options can also be sold by the traders, and they are known as option sellers. So when a trader sells any uncovered option, unfavourable movement can lead to significant loss.
5. Overtrading: The weekly options encourage a trader to trade more frequently; this can lead to high brokerage charges and emotional trading.
6. Risk Management: If a trader enters into an option trade without any proper risk management and position sizing, it can lead to higher losses than expected.

How to Reduce Risks in Options Trading

To reduce the risks in option trading, one can follow the steps mentioned below:

1. Understand Option Trading: Before starting option trading, one is required to understand the key terminologies about the option market, such as strike price, premium, expiry, time value of money, etc.
2. Small Trade: One of the easiest ways to control risk is to avoid putting too much capital into a single trade. It is advisable to start option trades with small positions.
3. Use Stoploss: A stop-loss can help a trader protect their capital from unfavourable market conditions. The exit point is to decide the exit level beforehand instead of deciding it emotionally.
4. Liquid Options: Liquidity is the key factor that one should consider before executing any trade. Liquid options allow one to execute a trade efficiently without making any delay. Also, it is advisable to avoid selecting an option simply because its premium looks cheaper.
5. Avoid out-of-the-money options: The premiums of out-of-the-money options look cheaper and tempting; however, they require large movements in the underlying asset to be profitable.
6. Time Decay: Options have an expiry date; their time value declines as the expiry approaches. This time value is known as theta or time decay. It is important for option buyers because if the underlying value of the asset moves in a favourable direction, there might be a slight or no movement in option premium.
7. Implied Volatility: It is one of the key factors that an investor should consider before making any investment in an option trade. If the implied volatility increases, the option premiums become more expensive and vice versa.
8. Hedging: One can also protect their loss in an option trade through various hedging strategies such as bull call spread, bear put spread, covered call, etc. However, it does not directly eliminate risk but only limits the loss.
9. Avoid Emotional Trading: Options are highly volatile in nature, and it can lead to fear and greed. Emotional trades such as holding a losing position in the hope of recovering it can lead to significant loss.
10. Avoid Unauthorised Tips: Various unregistered companies provide trading tips. They also promise huge returns from options trades along with guaranteed returns. One should avoid such tips and trade on their own. 

Read Also: Risk Management In Trading: Meaning, Uses, and Strategies

Who Can Trade in Options Trading

Options trading is generally suitable for the following investors:

1. Experienced Traders: Trading in options is generally suggested for traders who have vast experience of market movements. Along with this, option traders must have a better understanding of technical analysis along with risk management.
2. Risk Management: Traders who do not trade on an emotional basis can consider option trading. They must be able to set position size, stop-losses, etc. before entering into a trade.
3. Regular Monitoring: Option trading is suitable only for those investors who can regularly monitor their positions. Options nearing expiry can experience significant price movement.

Conclusion

On a concluding note, option trading is a great method to earn profit in the short run; however, not every trade ends in profit. Various factors that make options risky are leverage, time decay, volatility, etc. It is advisable to start with small positions and keep a strict stop-loss. There are various trading strategies that one should follow, such as a bull call spread, etc., allowing an investor to protect their position. At the end, it is advisable to take an option trade only after consulting your investment advisor and considering your risk profile.

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