Option trading provides wide options for traders to bet on the underlying security with buy or sell options with different price ranges and time periods. Options have a high potential to give returns in the shortest span of time, but at the same time, it also comes with several risk, that makes the option trading risky in terms of losing money due to losses.

Managing the risk in options trading is not only challenging but also very necessary to make your trading experience profitable and less risky. In respect of the same, we brought here a few techniques and trading strategies for risk management in options trading. It will help you to know how to manage risk in options trading in various market conditions.

What is Risk Management in Trading?

Risk management in trading is the process or technique of minimizing losses against various types of risks, like market risk, systematic risk and unsystematic risk. When you trade in the market there is a possibility the market can move in the opposite direction against your expectations, and managing such jeopardy is called risk management in trading.

Also Read: Types of Risks Associated with Investing in the Stock Market

To manage such risk in trading you can use several risk management techniques like analyzing the various factors that can create risk, measuring the magnitude of risk and taking the trade decisions based on such assessment to minimize the impact of risk. In trading, stop-loss and limit orders are the various popular techniques to manage such risk in trading.

What is Risk Management in Options Trading?

While, in options trading, the definition of risk management is quite similar, but owing to several complexities and derivatives in options, there are more multifarious and effective strategies used to minimize the risk of trading in index and stock options.

In options trading, apart from unsystematic risk and systematic risk, there are other risks like implied volatility, time value and time decay of options of the underlying security. You need to understand various types of risks, and align your trading strategy accordingly or apply the tools and techniques to minimize the impact of such risks in the options.

Two ways of risk management techniques can be followed. Passive risk management and active risk management, in the former you have to reduce your exposure to risk without making too many changes in the trade positions which includes placing the trade orders with predefined stop-loss and using the hedging strategies to offset your trade positions.

While in active risk management, you can have to use proactive methods like actively adjusting your trade positions as per the change in the market movement or increase or decrease of risk. You can also use the hedging to offset the potential losses.

How to Manage Risk in Options Trading?

To manage the risk in the options, you need to evaluate various factors that can create risk while taking a trade position in a particular underlying security or index. Once you estimate the risk you will be able to identify the strategy that will be effective in protecting your trade from the risk. And the entire risk management process involves the risk assessment and taking the right action as per the magnitude and possibility in diverse market conditions.

Risk Management Techniques in Options Trading:

Evaluation of Risks in Options

The first and most important step in risk management for options trading is the assessment of potential and various types of risk involved in options trading with the underlying security. Identify the systematic risk and unsystematic risk that can affect the option price with their magnitude of impact to measure how much the option can be affected.

In option trading, you can use the spread and calculation method to see beyond which level of market movement or underlying security price you will incur the loss. This will also show you the profit range and breakeven point or beyond which you cannot earn profits. For this, you should have expertise in drawing the option spread represented through a graph.

Identify Your Risk Tolerance

Now after evaluating the risk factors in option trading, you have to identify your capability to bear the risk, or how much money you can afford to lose in various market conditions. You should know your risk tolerance with the availability and requirement of funds, if you have kept the funds for any other purpose or can be required in urgencies then don’t bet.

Risk tolerance is directly associated with the amount of money you can lose in a single trade. In option buying the risk is limited but profit could be unlimited. While in option selling the profit is limited but risk could be unlimited. But in option buying you need less funds, while in option selling you need high funds as margin money is deposited with every trade.

Also Read: What is F&O Margin Penalty: SEBI Rules & How to Avoid it

Understanding the Option Greeks

Understanding the option Greeks is one of the most crucial and unidentified factors that every option trader must know to manage the risk in options trading. The option Greeks are Delta, Gamma, Theta and Vega which can tell you the impact of price change in underlying security on the option price. They all are interrelated or you can say derivatives of options.

Also Read: What are the Delta, Gamma, Theta and Vega in Option Trading

Delta measures the rate of change in option price due to changes in the price of the underlying security, while Gamma is responsible for measuring the sensitivity, magnitude or you can say the speed of change in option price in respect to change underlying price.

On the other hand, the Theta helps to know the impact of time decay or the erosion of option price due to approaching the expiry date. Finally, Vega is known for measuring the impact of volatility on option price, which means how much the option price is sensitive towards the change in the volatility, as high volatility increases the option price and low volatility decreases the option price.

Also Read: How to Trade in High Volatile Market: Best Trading Strategies

Choosing the Right Strike Prices

Picking the risk strike price in options trading is another crucial step towards options trading. Choosing a faraway like deep out-of-the-money or deep-in-the-money strike price from the spot price will have low trading volume and lack of open interest. While a strike price too close or at the money will cost you more as the option premium will be high.

Also Read: How to Choose or Pick the Right Strike Price in Option Trading

And at-the-money or in-the-money strike price options are highly sensitive towards the change in the price of the underlying security. However, in Call options and Put options choosing the criteria of strike price is different due to their different outcomes from the market movement. Hence always choose the right strike price in option trading to minimize your risk.

Perform the Technical Analysis

Trading without technical analysis is like shooting an arrow in the dark, there is no guarantee it will hit the target, and even in trading, you can incur losses. Performing the technical analysis in options trading is more important than knowing the right levels of buying and selling. You can analyse the volume trend, or interpret the open interest data.

Also Read: Importance of Volume in Technical Analysis: Use & Role in Trading

Analyze the candlestick chart patterns to know the current trend and next move of the price. In technical analysis, you can find out the support and resistance levels or draw the trend line, identify the buying and selling or points to book the profits or put the stop losses of the underlying security. And don’t forget to use the technical indicators for better predictions.

Using the Indicators for Options

Though, in trading there are unlimited indicators available in Trading View for option trading you use technical indicators like RSI, Moving Averages, Bollinger bands, Open Interest Change, Put-Call Ratio and Implied Volatility etc. As per your option strategies apply the best suitable technical indicator that can give you better insights about the options.

Also Read: Best Candlestick Patterns for Day Trading and Option Trading

You can analyze the price of the underlying security and its trend based on that you can choose the option contract. As the option price or premium is directly related to the spot price of an underlying security. Though, other factors like Delta, Gamma, Theta and Vega also determine the price of an option and also helps to know how the premium changes.

Using Stop-Loss as a Safety Net

One of the best to way manage the risk in trading or option trading is use the safety net to limit your losses further. Stop-loss is the safeguarding technique that can minimize the impact of risk if the market or underlying security does not move as per your expectations.

You can use the predefined stop loss orders either the fixed stop loss or trailing stop loss that can automatically adjusted as per the option price movement. And to minimize your losses you can also book partial profits on the significant move of the option price. Using the stop loss is like minimizing the risk of losing more money and exiting from your trade position.

Also Read: What is Profit Booking in Stock Market: Rules & Best Strategy

Trade with the Hedging Positions

In option trading, as the name suggests you have options to choose from various underlying securities or from various strike prices or enter into multiple trade positions at the same time. Here you can use the most effective risk management technique called Hedging in which you can buy or sell the combination of calls and puts to offset your trade positions.

As per the market condition and trend of the underlying security you can trade with a hedging-based option strategy that will allow you to enter a trade position that you can adjust as per the market movement. Such hedging strategies will give you profits, with the option to minimize the impact of risk, if the market starts moving in the opposite direction. The hedging strategy can vary as per the level of risk in option buying to option selling positions.

Risk Management in Option Buying

When you buy an option, either it is call or put, the risk is limited to the option premium you paid for the option. In option buying you have no obligation to fulfil your trade position, hence no matter how much the price of the underlying security moves against your expectations. Here you cannot lose your money more than the premium plus your trading fees.

Buying an option is already protected with limited risk, hence there is no need to manage the risk. In option buying the profit could be unlimited if the underlying price moves unstoppably. However, to minimise the impact of this risk in option buying you can hedge your trade position by selling the options to offset some of your losses but it will increase your transaction cost.

Risk Management in Option Selling

The risk in the option selling could be unlimited as there is a limited return. When you sell the option, you get the premium but have the obligation to sell the underlying security at the agreed strike price within the limited time frame whatever the price is. And if the price of the underlying security moved against your option strategy you will incur the loss.

Also Read: Why Option Selling is Better than Option Buying: Explained

In option selling, the best way to minimize the risk is to hedge your positions with covered calls. This means you should have the physical shares of the same underlying security in the same quantity so that you can deliver the shares if the option buyer chooses to exercise the option contract. Here you can minimize the risk as you don't have to buy the shares at a high price.

Also Read: How to Convert Physical Shares Into Demat: Stepwise Procedure

Final Thoughts

Risk Management in Options Trading is the art of minimizing the impact of various factors that can work against your trading strategy. Reducing the risk in option trading will not only minimize your risk, but it will also reduce overall losses and maximize the rate of returns.

Also Read: What are the Top Factors Affecting the Stock Market in India

To implement risk management effectively you have to understand and assess the types of risk in options trading. Evaluate the risk, and its impact on option premium in various market conditions and while understanding your risk tolerance choose the right strike price and option strategy. The best tools are to use the stop-loss and trade with a hedging strategy.

And more importantly, to know how to manage risk in options trading always trade with the market expert who has better knowledge and expertise in managing such risks. You can open a demat and trading account with Moneysukh, and get the best online trading platform for trading in stocks, commodities and derivatives. Here you can trade the best options strategies as per the market conditions recommended by the derivative analysts for best results.

Also Read: How to Find or Determine Undervalued Stocks: 10 Best Ways