2 Costly Errors When Trading Options

Trading is an easy way to go broke if you don’t adhere to good risk management protocols. Options trading allows you to leverage a fraction of the amount it would take to get involved in trading stocks.

Risk management helps cut down losses and protect your trading account.  The issue is that this essential part of trading is often ignored.  A few bad trades can wipe out your trading account and this is something that happens to many traders.  This leverage can magnify your losses if you don’t take steps to avoid it.

In this post, we will show you how to use risk management when trading options that can prolong your trading career.

Common Risk Management Approaches

Taking on risk is how we make money trading anything, including options.  One of the rules of thumbs in regards to risk is to not put more than 2% at risk on a trade.  What do many traders do?  Options traders think this is a “can’t lose trade “and risk multiples of the 2% general rule.

Some traders look for a simple approach.  Their risk management technique revolves around trading one options contract for every trade.  Is this a good method to take?

Both of these have risk exposure issues that, if not addressed, can lead to unreasonable risks that do not have to occur when trading options.

The one big safety feature of trading options is that your potential loss is only the premium you paid for the options contract.  It is fairly simple to follow the lead of successful traders and properly protect your downside, but many do not.

Multiples of 2% Risk

This issue by itself is not the problem.  The problem is when traders use huge risk on one or two positions as you look for the home run win.  At Netpicks, we’ve seen traders buying options using 15-20% of their account size.

This is a disaster waiting to happen as they roll the dice looking for the big win.

We all know that a string of losing trades is the reality.  There will be winners and break-even positions wrapped up in there as well.

Imagine you were bullish on XOM and bought an ITM call option with 17 days left to expiration at $3.15 or $315/contract.  That $315 is the maximum you can lose if the trades goes against you.

If you are trading a $5000 account and decide that you will risk 20%, you are risking $1000 dollars.  You do the quick math and decide you can buy 3 contracts.  While the payoff could be good if you win but if you lose, you will end up losing up to $945.  A few trades like that, and you can see how fast you can deplete your trading capital.

Spread Risk Around

How about taking that same level of risk, your 20%, and spreading it across multiple trades instead of all the eggs in this basket?  You will have a more diversified options portfolio (instruments/sectors) and could use more advanced options strategies outside of simple calls/puts.

Trading One Options Contract Technique

Traders that decide that their risk tolerance only allows them to trade one contract ignores the reality that the cost to trade depends on the underlying.

In this example, let’s compare buying an ITM (in the money) call option on TSLA with 31 days to expiration.

The ASK price is $20.85 or $2085 per options contract. Remember, each options contract is equal to 100 shares of the underlying stock.

Compare that to an ITM call option on Citigroup with the same 31 days to expiration.

One contract will cost you $254, a fraction of one contract of TSLA.

Remember, this is the premium you will pay to have the right to purchase either of these at some time in the future at the strike price related to your cost.  It’s also the maximum you can lose on the trades.

If you had a $5000 trading account, you can see that using the one contract rule, TSLA could cut your account in half with a full loss. It’s obvious that the one contract rule won’t work.  If fact, with Citigroup, you would not be maximizing the potential rewards by using such a simplistic risk strategy.

Set Your Amount

In our options trading program, we highly suggest that traders set a dollar amount for risk that is uniform across all trades taken.  Whether it’s $200 or $2000, that amount will apply to every trade.

If you decide on $2000, you’d not be able to take any TSLA positions in our example, but could hold 7 contracts of Citigroup.

For many of our newer traders, this set dollar amount is a breakthrough for them. Plus, it helps them understand what their risk is really costing them. If they want to increase their risk, they can. They just need to adjust their dollar amount accordingly.

Personal Risk Tolerance Approach

Everyone is unique in terms of funding amounts and risk tolerance.  This is just an example of how our in-house options team handles risk.

First, risking no more than 50% of the account at any one time is paramount.  This amount is spread across multiple positions and strategies.  If you are trading a $15000 account, no more than $7500 will be in play at any one time.

The second stage is risking no more than $500 on any single trade.  This means that some trades will involve 5 contracts while another may involve 10 contracts.  Your account size will determine your figure however we look at 2-3% risk.

Keep in mind that this is maximum risk.  It does not mean we let option trades take the full loss.  This is because of the trade management approach that we take that will be covered at a later date.

Third, we use a mix of options strategies including calls, puts, spreads, as well as different sectors.  We also use a strategy that allows us to profit in 5 different ways on one position.

 Conclusions

While risk management is always important when trading options, it is especially crucial when you are starting out. By using too large a position, you run the risk of depleting your account before you have had a chance to see any profits. Additionally, by only trading one contract at a time, you ignore the price of the underlying stock and could be taking too large a risk or not maximizing the potential of the trade.

A better strategy is to use a small percentage of your account per trade and set a dollar amount that you are willing to risk on each option. This will help ensure that your trades are profitable in the long run and limit your losses if things don’t go as planned.

To get started with options trading, download our free 8 Minute Options Cookbook guide. You will learn how we can generate profits 5 different ways in only a few minutes a day.