Basic Options Risk Management
A basic rule of thumb with options trading, is to play with what you are willing to lose. As opposed to stock trading where you might be willing to lose 4-6% of your investment per trade.
Does this mean that options are too dangerous and risky to trade? No! They just have to be approached in a certain way for consistent profitability. I personally see options trading as a better way to manage risk and maximize your portfolio’s gains.
Let’s look at a example of an Options Trade vs. a Stock Trade.
In this example, we will have 2 people trading the same stock. One will buy the stock itself and the other will use call options.
The sample stock is XYZ trading at a price of $30/share.
Jim Stocktrader buys 1000 shares of XYZ, which costs him $30,000.
Joe Optionsguy buys 10 contracts of XYZ, which exposes him to the same amount of shares. (Each contract controls 100 shares) The price per contract is $1.00. So, Joe’s investment cost is $1,000. (Therefore, he’s putting $29,000 LESS at risk than Jim Stocktrader)
- The most Jim Stocktrader can lose on this trade is $30,000.
- The most Joe Optionsguy can lose trade is $1,000.
SCENARIO 1: Stock Goes Up +$10
If the stock went up in price before the expiration of the contract, this would of course, be a win for both traders. However, let’s take a look at the numbers.
- Jim Stocktrader risked $30,000 and made $10,000 a percentage gain of +33.3%
- Joe Optionsguy risked only $1,000 and made $9,000 a percentage gain of +900%!
A great win for both, but the options guy put much less at risk and had almost the same gain. That’s a big win for options traders.
SCENARIO 2: Stock Goes Down -$10
If the stock goes down in price before the expiration of the contract, this would be a loss for both traders. Let’s take a look at the numbers.
- Jim Stocktrader risked $30,000 and lost $10,000 a percentage gain of -33.3%
- Joe Optionsguy risked only $1,000 and lost $1,000 a percentage loss of -100%
Having only risked $1,000. Joe Optionsguy shows the power of options trading once again. While the “-100%” looks scary, Joe Optionsguy played it right and walked away only losing -$1,000 compared to Jim Stocktrader who lost 10 times as much (-$10,000)!
You can see from the way this played out, when traded properly, options trading can give you the opportunity for very large gains, while protecting you from large losses.
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