Option Selling Risk
Selling futures options puts you in a situation where you can have virtually unlimited risk on every option you sell. A trader has to be very vigilant to make sure things don’t get out of control when a position starts to move against the trader. There will inevitably be a runaway market that moves against you when you sell options. Realizing this will happen and getting out at a predetermined level is key to long term success.
Many new traders keep a dollar amount of risk in the back of their minds where they will exit a position, but that often changes when it happens in real life. It is tempting to just watch the market a little while longer and hope it will turn around. Sometimes the market will turn around and but it often doesn’t.
The important thing to remember is risk control. You don’t want to let one bad trade destroy your account. This will eventually happen if you don’t close positions out at predetermined levels and put yourself at the mercy of the markets. Professional traders get out at predetermined levels and know their amount of risk before they even place the trades. Novice and unsuccessful traders usually just watch the markets and determine when to get out after the fact.
The correct way to manage risk when using an option selling program is to know where you will get out of a position before the trade is executed. A basic approach option sellers use is to hold positions until they expire or the option premium doubles. Under this strategy, traders will either make 100 percent or lose 100 percent on each trade. As long as you win on more than 50 percent of trades, not including commissions, this makes for a profitable strategy. Professional traders have much more sophisticated risk management strategies, but this is a basic idea to consider.
Option Buying Risk
Many traders prefer to buy options, because you can’t lose more than you invest on options you buy. This level of comfort comes with a price. Theoretically, options lose time value every day and eventually expire worthless if they are out of the money. Time is a big factor for option buyers, which means that risk control is just as important for option buyers as option sellers.
A key mistake option buyers make is to hold on to their options until they expire worthless. They either take quick profits or their options expire worthless. Even if they held their options until they doubled in value or expired worthless, they would have to win on more than 50 percent of their trades to show a profit on their trading account.
Doubling your money on more than 50 percent of option buys is not an easy thing. Therefore, controlling risk means that you can’t let all your options expire worthless. Many professional traders only hold on to their options for a few days to avoid losing too much time premium. Either a trades works quickly or they get out.
A more realistic alternative might be risking 25 percent on an option premium and holding out for a 50 percent gain. These are rough numbers, but you will have to create a strategy that fits your trading style. Being realistic and being able to cut losses is very important to a profitable option buying strategy.