How to Turn the Risks of Options Trading to Your Advantage
With any business venture, there are always risks – and the risks of options trading are no different. Understanding these risks is crucial to successful trading. In fact, launching boldly into the world of options trading without knowing what you’re up against, is like a business without a strategy or sense of direction.
If you want to make a regular income from options trading you have to approach it with the mindset of a business person. You have to do your SWOT analysis – strengths, weaknesses, opportunities, and threats. This article is primarily about the “weaknesses and threats” aspect.
Enemy Number One – Time Decay
Options are unlike any other derivative financial instrument in that their value decays with the passing of time. During the final 30 days of an “out of the money” option’s life, its value decays at a much faster and more exponential rate than in all its previous life. It is a reflection of the decreasing probability that the options contract will be “in the money” at the expiration date.
You need to be aware of this, the most notorious of all the risks of options trading, and use it to your advantage when implementing your option trading strategies.
If you know who your enemy is, you can not only avoid the dangers of approaching it the wrong way, but in the world of options trading, you can also turn this enemy into your best friend.
One of the great advantages of options trading is that you can not only BUY option contracts but also create new ones out of nothing and SELL them to the market. We call the ‘buying’ end ‘going long’ while the ‘selling end’ is ‘going short’. Most of the risks of options trading fall into the lap of those who ‘go long’ options, due to the disease of time decay.
If you buy options in the hope of selling for a profit, you need to feel sure that the underlying stock, commodity, ETF, or whatever, will move to your desired target reasonably quickly, otherwise, time decay will eat into your profits. There are ways to minimize this, such as buying “deep-in-the-money” options, where most of their value is “intrinsic value” and less “time value”.
Another alternative is to purchase long-dated options, i.e. with an expiry date at least 90 days away. This will give you more time to be right and provided they are ‘in-the-money’ will be less affected by time decay.
Your Enemy Becomes Your Friend
So how can you use time decay to your advantage and minimize the risks of options trading? We have already mentioned that you can SELL (go short) options contracts as well as buy them. This allows the trader to construct combinations of long and short positions in a way that uses time decay to your advantage.
It is well known that on average, 85 percent of options contracts expire worthless. So that means that if you’re on the selling end of the deal, your average risk is reduced from 85 percent to the remaining 15 percent who have sold those contracts.
There are a number of option trading strategies that allow you to do this, such as credit spreads, butterfly spreads, iron condors, ratio spreads, and covered calls. We describe these in more detail on other pages at this site. Feel free to browse around and discover the many ways you can use ‘short’ options to reduce the risks of options trading.
Another risk, which is not limited to option trading, is the need to be able to predict the future direction of the underlying market in order to profit. But did you know that there are option trading strategies such as the straddle or options strangle, which allow you to effectively take a bet both ways?
You don’t care which way the market moves, as long as it goes somewhere within a short space of time. The run-up to an upcoming earnings report is one of the best times to implement this strategy, as markets are anticipating the impending news.
Range Trading Strategies
Since time decay is “enemy number one” among the risks of options trading, it is at its worst when market price action is going nowhere. Sideways trending markets can kill an option’s value very quickly. But if you’re on the selling end of such a contract, it is where you make your profit. There are a number of options range trading strategies you can take advantage of which are also outlined on this site.
Risk vs Reward Ratios
One of the most important aspects of speculative trading of any kind is risk management. A trader who invests too much in any one trade is asking for trouble. If the trade doesn’t go according to plan, you may wipe out your trading capital in a short time. So it’s vitally important that only a measured portion of your capital is used on any one trade.
The level of risk management will depend on the type of leverage that is being used. For example, trading futures and spot forex pairs come with a different type of risk than trading options, because these two instruments can lose much more than your initial investment. Long options, on the other hand, have limited risk, which helps a lot with trading psychology.
For traders buying simple long positions, risking a maximum 20 percent of your capital on any one trade AND taking a maximum 20 percent loss on that trade, is a good policy. Why? Because 20 percent of 20 percent is only 4 percent of your entire trading capital.
The risks of options trading need not be feared
– if you know how to handle them. Options are very flexible in that positions, once entered, can also be adjusted as you see market price movements taking shape. Even losing positions can be turned into winning ones.