Managing Risk in Your Option Trades

Your risk in any option trade must be analyzed. You can’t just say this option trading strategy is high risk or that strategy is low risk. You must take a number of factors into account before making that call. You need to take a look at the big picture.

Here’s a great article by my favorite options trading author, Michael Thomsett, in which he explains how to analyze the risk of the specific trade you’re considering. Check it out…

Can options actually provide conservative portfolio management? Putting this another way, is it possible to reduce risk while increasing profit?

Most conservative traders think about options as high-risk. But in fact, they do not have to be. Some very conservative options strategies can be used to reduce portfolio risks while creating income. However, thinking beyond the traditional view of risk as being related to a strategy, there is another way: to see risk as a matter of when and how you place an option trade.

In this definition, a strategy is not necessarily high-risk or low-risk. It is a matter of checking implied volatility and probability to time entry and exit. This is a new and interesting way to view risk. It can even lead to viewing “safe” strategies like covered calls as high risk if they are opened at the wrong extreme on the volatility scale, with the wrong strike, or at the wrong expiration. Just as interesting, a “risky” strategy like an uncovered call could become relatively conservative if opened and closed at skillfully picked moments on the volatility cycle, the expiration swing, and the probability level.

The exciting aspect of this redefined way of looking at risk is that it becomes a variable. No single strategy can be exclusively assigned a risk level because its true risk depends on its implied volatility, probability, and of course proximity and timing (strike to current value of the underlying and selection of an expiration). Even long-time options traders may reconsider how they view risk itself. The traditional and widely accepted definitions do not apply in every case, and assuming a particular strategy is always defined in terms of its inherent risk is a mistake.

A few of the basic traditional conservative option trades include covered calls, protective puts, collars, synthetic long or short stock, and buying LEAPS calls as a form of contingent future purchase (or selling LEAPS puts to expand insurance and provide contingent future sale while preventing losses if and when the underlying loses value).

Here’s the problem. If you enter these trades or exit them at the wrong point in the cycle of volatility, you have been chasing conservative trades that might actually be high-risk. These typical conservative strategies are, of course, safe compared to uncovered calls or short straddles opened at the same volatility level. But the question of how you define “conservative” and where you identify risk opens up a lot of questions about options trading itself. Remember the proposed definition of conservative: a strategy or strategies designed to reduce risk while increasing profit.

Even a basic analysis and comparison reveals that some “high-risk” strategies, like short puts, for example, may be quite safe compared to perceived “low-risk” strategies that actually expose you to greater market risk. For example, as of the close on March 22, look at the following options for Apple (NASDAQ: AAPL), which closed at $599.34:

  • March 23: 595 put (expires in one day) 1.46
  • April 21: 575 put (expires in 30 days) 10.80
  • March 23: 600 call (expires in one day) 2.67
  • Apri1 21: 605 call (expires in 30 days) 18.55

With only one day until expiration, the March 595 put is more than four points out of the money, and the 1.46 premium provides downside protection to $593.54 per share (595 strike less 1.46 premium). If you believe the stock has support at these levels, selling this put may be viewed as low-risk, considering exposure only lasts until the close of the next day. A similar argument can be made for selling the March 23 call with 600 strike. Premium of 2.67 protects the position up to $602.67 per share, or 3.33 points higher than the close on Thursday. Again, this could be perceived as low-risk given the one-day exposure.

Now compare the April puts and calls. You could short straddle these, selling the April 605 call at 18.55 and selling the April 575 put at 10.80. This builds a “safe” range between $545.65 and $634.35, or 88.7 points. This is calculated by adding together the premium income from both options (18.55 + 10.80 = 29.35). Then reduce the put strike of 575 (575 – 29.35 = 545.65); and increase the call strike by the same amount (605 + 29.35 = 634.35).

The net range of the short straddle contains a “safety zone of 99.7 points (634.35 – 545.65 = 88.70). Even with a company as volatile as Apple, this is quite an impressive profit zone, and may be viewed as highly conservative3 considering the rapid time decay you would expect during the coming 30 days. Furthermore, exposure is easily reduced by closing, rolling forward or covering one or both sides based on price movement. Time decay could make this short-term short position very conservative.

This is food for thought.

With options properly structured it is possible to identify low-risk ideas and make the whole process of portfolio management quick and easy.

See Michael Thomsett’s entire article at

Option Trading Secrets