Basic Options Risk Management

by · February 2, 2015

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.

What’s Next?

Start Reading About the Different Types of Option Trades »