Three Ways to Manage Risk in Options

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Three Ways to Manage Risk in Options

There are many ways to improve as a trader. Knowing the right times to buy and sell the right stocks is obviously important, but risk management is often the real strength of individuals who succeed in the market. Knowing how to minimize losses doesn’t just protect your capital – that’s obvious. It can also keep your emotions in check, letting you make the best decisions when opportunities come along. As an options trader, you have various ways you can use options to manage risk. You can buy puts outright Puts fix the price where a stock can be sold, so they gain value when shares move lower. Think of this like insurance; it’s cheaper before an accident or illness occurs.

  • Buying puts outright means you only purchase contracts in a single option (same strike and expiration), unlike the vertical-spread strategy outlined below.
  • Advantage: Simplicity is the main benefit of buying puts outright. You stand to keep making money if the stock continues losing value – all the way down to zero.
  • Disadvantage: Cost is the main drawback of buying puts outright. They often cost more than spreads and require bigger moves to break even.

Other variables, like time and volatility, impact option premiums. We’ll explore those in another blog post. Also remember we’re talking about using puts as a hedge, or protection, on a stock. Our approach will often be very different when taking directional positions. In those cases, we might want much shorter-dated contracts. You can target specific levels with vertical spreads Another useful options technique is the vertical spread: buying one put near the money and selling another further from the money. It requires the same number of contracts at different strikes, but the same expiration. The vertical spread essentially controls, or leverages, a move between two specific levels on the stock’s price chart. It has two advantages but one drawback.

  • Advantage: Selling puts generates income, reducing the overall cost. As a result, vertical spreads are cheaper than buying puts alone.
  • Advantage: Vertical spreads target specific points on the chart. Traders watch the pivots and have opinions such as “if XYZ stock breaks under level A, it’s headed down to level B.” Using vertical spreads as protection can let them remain in their positions while also hedging against the potential pullbacks they may anticipate.
  • Disadvantage: Vertical spreads only have limited profit potential. They stop making money once the lower strike price is reached. This is a big difference from outright puts, which keep gaining value all the way down to zero. It also means spreads provide more limited protection.

Liquidity is another concern with vertical spreads because the strategy includes two transactions, a purchase and a sale. Both halves of it have bid/ask spreads. Traders can minimize these transaction costs by using highly liquid stocks and exchange-traded funds (ETFs). You can sell calls against stock Covered calls are pretty much the most basic options strategy. It entails owning a stock and then selling calls against it. You collect money upfront and agree to surrender your shares at the strike price if it’s above that level on expiration. Selling calls can be a very effective way to take profits in a stock after a rally. There are a few things to consider:

  • You can sell calls under the current price of the stock. Collect all the value above the strike price as intrinsic value, essentially “cutting the top off” your position. Take the cash now and only leave the value under the level you sold as risk. That way, small pullbacks literally have no impact on your account. It can be useful when traders want to exit a position.
    • For example, you buy a stock for $30 and it rallies to $40. Selling $35 calls protects you against a $5 drop and increases the likelihood of your shares getting sold.
  • You can sell calls “at the money,” or a strike close to the shares’ current price. Contracts like that have less intrinsic value but more extrinsic value. As a result, they will depreciate quickly from the stock moving sideways. Remember we like selling things that are losing value! Investors who think the stock is just pausing within a bigger uptrend may favor the “at-the-money” approach.
    • For example, you buy a stock for $30 and it rallies to $40. You think it will pause for a few weeks before continuing to $45. Short-term calls at strikes like $40 or $42.50 have a higher probability of expiring worthless. So, they can be sold to generate income, while leaving open the possibility for more gains in the stock.
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