Options trading is a form of financial derivative trading that allows traders to speculate on the price movements of underlying assets without owning any units. Options traders buy contracts that are called ‘options’ to trade these underlying assets. In other words, options are legal contracts that allow – but do not oblige – traders to buy or sell an instrument when the contract’s expiration date arrives.

Options trading can be risky depending on what underlying instrument is being traded, and it is important to understand what risk management techniques you can put in place. Below, we explore a few of them. However, before we delve into risk management techniques, we look at defining risk management, why it is important, and the common risks that options trader encounter.

What is risk management?

Risk management is a process traders engage in with the goal of limiting losses. Traders do this through four main processes – identifying risks, assessing risks, controlling risks, and reviewing their controls regularly. Risk management is not a static process, and it requires the active management of traders to ensure they are up to date and effective.

Why manage risk?

The most obvious reason why traders manage risk is to limit the potential for losses and to increase their bottom line. Risk management is a way for traders to prevent potential problems before they happen. They do this by putting security measures into place.

By curbing potential risks before they become a problem, traders can increase the chances of their success when trading. Successful risk management can also allow traders to focus on honing their skills and to trade more efficiently. This can help them potentially generate more profits in the long run, if they stick to their plans.

Risks in options trading

The main risk encountered with options trading is market risk. When the market performs adversely and against expectations, traders who buy options contracts may find themselves unable to execute their option. They then run the risk of letting their option expire without exercising it, wasting the amount of money they spent to purchase the contract.

Another risk traders encounter in options trading is that of leverage risk. Traders are allowed to magnify their positions with the use of leverage when they purchase an options contract. If the market heads in a direction they do not expect, they may risk encountering serious losses that exceed their initial investment.

Risk management techniques for options trading

Now that we have defined risk management and identified some of the risks associated with options trading, we look at some techniques we can use to limit potential losses.

Research the market well

The first step to increasing your chances of success when options trading is to research the market well. Whatever instrument you want to trade, learn about the factors that drive its prices and keep an eye on these factors. Dissect its historical trends and price patterns, even if they are not indicators of future performance. Figure out how a market’s traders have historically participated in the market – when they bought and sold – and learn from other traders’ previous mistakes.

Research is a great way to lay the groundwork. If you are unsure about where to start, you can always start with an instrument’s price chart. Check out its historic highs and lows. If you are purchasing a stock option, make sure you know what company you intend to speculate on and the management style of the company.

Establish a trading plan

Another thing that greatly helps traders is when they establish a trading plan. This is incredibly important, as it acts as a guide for traders to follow and can potentially prevent impulsive trading. A plan may include the instruments and products a trader may trade, their budget, risk tolerance, time of trading, and their goals.

Another thing traders include in their trading plan is the broker they choose. Not all brokers are made equal, and there are certain brokers that prefer certain modes of trading. Finding one that suits your needs will take you a long way. Consider transactional fees, commissions, cash deposit and withdrawal methods and costs.

Be consistent with your trading plan

When you have set up a trading plan, one way you can limit your risk is by sticking to your plan. Your plan does not have to set in stone and there is room to deviate from the rules and parameters you set for yourself. However, it is best if you stay consistent. When you need to, you can review your plan to see if it still aligns with your current goals and budget, risk tolerance, and trading style.

Hedge your positions

Many people may use options trading to hedge their trades, but they can also hedge their options trades. This is especially true if there is great volatility in the market or if there are unexpected fluctuations. It is then you should hedge your existing positions to avoid potential losses out of the markets behaving adversely. For example, if you have sold calls and puts, you may buy far out of the money calls and puts to hedge your existing position.

Diversify your trades

Even when you are buying options and not directly purchasing stocks, commodities, and other instruments, you may want to consider diversifying your trades. You can do this by looking at different sectors, companies, industries, and types of options trading strategies. On one hand, this can mean purchasing ETF options instead of single stock options. This can allow you to diversify your portfolio slightly, and if one company does not do well, you will not see such great losses.

On the other hand, you can diversify your options trading strategy. Mixing bullish and bearish strategies can offer you limited protection. However, you should ensure that you do not accidentally wipe out your trades when you take on positions arbitrarily.

Thirdly, you can diversify your options trades by timeframe and expiration date. Options contracts have expiration dates, and traders need to exercise their contracts by a certain date depending on their options style. If you want to buy and sell several options contracts simultaneously, you should vary their expiration dates. This can free you up and prevent you from being held hostage in the short term.

Select a reputable broker

At the end of the day, who you choose to work with as a broker makes a huge difference. Ensure that you work with a reputable broker that can offer you the instruments you would like to speculate on. You should also make sure your broker offers adequate customer support, so that you can get in touch with them quickly if anything arises. A good example of this is Saxo Bank.

The bottom line

Risk management is crucial regardless of the product you trade. In options trading, we can clearly see why. Ensuring you protect your capital not only reduces your potential for loss by limiting your exposure to market risk, but it allows you to trade more smoothly and efficiently. If you are unsure of how to get started on your risk management strategy, you can open an account with a broker and seek professional help. Alternatively, you can use resources online to help you take the first step.