Understanding risk tolerance in options trading is one of the keys to successfully maneuvering the market and maximizing your profit potential. Developing a risk tolerance profile is needed—this is where traders or investors determine the amount of loss they can realistically handle while making their investment decisions. Once their risk tolerance has been established, traders can make better-informed trading decisions where they can take on risks that are proportional to their financial situation, time horizon, trading experience, emotional resilience, and investment goals.
Keep reading, and our guide will help you assess your risk tolerance and align it with appropriate options trading strategies. Find out if your approach is conservative, moderate, or aggressive—you can then begin devising a strategy for your next trading session where you’re taking on the appropriate risk to experience an increase in profit!
What Is Risk Tolerance in Options Trading?
Risk tolerance is a trader’s or investor’s willingness to accept losses in exchange for potentially higher gains. The long and short of risk tolerance is how much risk the trader is willing to take on when trading online option contracts.
Risk tolerance differs from trader to trader. In the context of options, there are high and low-risk tolerance approaches to trading these securities. Those with a higher taste for risk are typically more aggressive options traders who are willing to use higher position sizing or use strategies that are “high-risk, high-reward.” Lower risk tolerance is the hallmark of traders with a more conservative approach where they use strategies that produce predictable, steady return over time.
Several factors ultimately influence risk tolerance with investors and they can be strategic and financial as well as psychological. Individuals with secure financial situations tend to have a higher risk tolerance compared to traders with limited capital. High market volatility can increase large loss potential which ultimately impacts someone’s risk tolerance. Plus, there’s the situation of short-term vs. long-term goals and how different approaches might be suitable for one and not the other.
Key Factors That Influence Risk Tolerance
How does risk tolerance vary from one trader to the next? Let’s take a quick look at the key factors that influence risk tolerance and can help you gain an understanding of what makes investors or traders tick when it comes to how open to or closed off to risk they are.
- Financial Situation: The better someone’s financial situation might be, the more willing they could be to take on risk in options trading. Higher-income can provide traders with the capital needed to take on riskier trading maneuvers. Other financial factors include a trader’s savings, investment capital, and financial obligations, all of which could impact how open or closed off they are to risk.
- Investment Experience: The more familiar one becomes with the options market, the more likely they are to begin experimenting with taking risks on their option trades. This comes with finding out ways to navigate almost any market condition and still being able to make money. Once traders or investors get these concepts down pat, they’re usually much more open to risk a bit more than they’d usually be comfortable with on their trades.
- Trading Goals: The general rule of thumb with this factor is that traders are more willing to take bigger risks with their short-term trading goals, while they might take a more conservative approach to trading when attempting to reach their long-term objectives.
- Emotional Resilience: Some investors have a higher emotional tolerance for potential losses on option trades or for market volatility. Emotional resilience can be improved with things like a comfortable emergency fund or a stable income. Those who can’t mentally handle market downturns or are prone to anxiety might be investors who have a lower tolerance for risk.
- Time Horizon: The length of time available for investment impacts risk appetite as investors with longer horizons can take on more risk as there’s enough time to recover if they make mistakes. A good example is an investor who is 20 versus one who is 60. The 20-year-old can take on more risk (provided they have the same amount of money to work with as the 60-year-old) because they have 40 or so more years of work ahead of them versus the older investor who cannot afford to fiddle around as much with the money they need retiring.
Risk Tolerance Levels and Their Corresponding Options Strategies
Because there are different types of traders with different risk tolerance levels, there are different options strategies that will be best for traders who have higher or lower tolerance for risk in their trading sessions. If you’re trying to figure out which option strategies work best for your approach to trading, we’d encourage you to keep reading as we outline the best approaches for conservative, moderate, or aggressive traders.
Conservative Traders (Low-Risk Tolerance)
The calling cards of conservative traders are the prioritization of capital preservation and embracing low-volatility trades instead of high-volatility moves, which could potentially result in higher profits. These traders gravitate toward low-volatility assets and trading strategies that prioritize risk management.
Suitable Strategies
- Covered Calls: This trading strategy involves selling a call option on a stock that you already own, where investors can enjoy income generation with reduced risk. They collect a premium when they initiate the sale, and then they wait to see if the call is exercised or expires as worthless. Covered calls are a good move for beginners and those who expect the price of the stock to either moderately increase or remain flat.
- Cash-Secured Puts: This beginner strategy involves selling a put option while simultaneously setting aside the cash needed to buy underlying stocks if it goes to assignment. Not only do traders generate income by collecting a premium on the put’s sale but there’s also the chance they can buy the stock at a lower price. It’s a great way for newer traders to enjoy a controlled entry into stocks.
- Credit Spreads: Traders must simultaneously buy and sell options on the same asset. These assets have the same expiration date, but different strike prices. The goal with this one is to profit from price movements in the underlying asset. Credit spreads result in a net credit if the premium from selling the option is higher than the premium paid for the option when it was purchased. It’s a well-defined risk with premium collection potential.
Moderate Traders (Medium Risk Tolerance)
Moderate traders are best described as those who trade stocks or options in a way that’s not active or very inactive. These are investors who are willing to take calculated risks for better returns. They aren’t as fearless as some of the more aggressive investors, but they aren’t all about low-volatility plays that prioritize risk management.
Suitable Strategies
- Iron Condors: This moderate strategy profits with options that have a stable underlying asset. It’s a combination of a call and put spread (both vertical) which have the same expiration date but different strike prices. While selling an out-of-the-money call and put, plus buying an even further out-of-the-money call and put, the trader receives a net credit (option premium), which they can keep if the underlying asset remains within the range of the sold options. Iron condors are limited risk and they can produce steady income.
- Debit Spreads: The trader buys an option with a higher premium and sells an option with a lower premium at the same time. These options provide controlled risk directional trades where traders pay a premium and profit when the price moves in the expected direction. It’s good for moderate traders who are feeling bullish or bearish on a stock, but they don’t incur the heavier expenses that come from buying calls and puts.
- Straddles on Low-Volatility Stocks: Traders can use the straddle strategy to profit from potential volatility increases on low-volatility stocks. This move involves buying and selling a call and putting an option on the same underlying asset with the same strike price and expiration date. It’s a profitable strategy when the price of the asset moves more than the premium paid for the trade.
Aggressive Traders (High-Risk Tolerance)
Aggressive traders are those who are comfortable with high-risk and high-reward trades with the goal of making large profits quickly. Oftentimes, these investors will use options or borrowed money to increase their trading capital and regularly use market timing techniques to generate returns that are above average compared to their peers. They might only hold positions for a short time and typically place market orders to ensure immediate execution.
Suitable Strategies
- Uncovered (Naked) Options: This advanced strategy is where sellers don’t own the underlying asset; they make a profit if the option expires as worthless, but they could lose a lot of money is the price of the asset increases or if the buyer exercised the option, forcing the sellers to buy the asset and sell it to the buyer. It can come with high reward, but there’s unlimited risk, making it a popular move with aggressive investors.
- Straddles and Strangles: Both of these strategies have traders profiting from extreme market movements. When it comes to straddles, the long straddle is the one that is suggested to aggressive traders if volatility is expected in the market. Strangles are some of the most aggressive trades which result are characterized by “high-risk, high-reward.” Because it has the highest negative theta of most trades, it will lose the most if the stock doesn’t move and/or the implied volatility doesn’t increase enough to offset theta.
To learn more about these aggressive trading moves, check out this guide for more details: Straddles vs. Strangles | Key Differences & When to Use Each.
- LEAPS Options: These are long-term high-risk/high-reward investments, which are long-date call or put options listed on stocks or indices. Offering investors an alternative to stock ownership, LEAPS calls let traders benefit from stock price rises while risking less capital than is needed to purchase the stock in the first place.
To learn more about LEAPS options, check out the following guide: LEAPS Options 101 | A Strategic Guide for Long-Term Growth.
How to Assess Your Risk Tolerance
You might already have a general idea of what kind of trading style you’re into and how much risk you’re willing to take on, but how can you know for sure that your approach is conservative, moderate, or aggressive? We’d suggest looking over a few of the self-assessment questions that get to the heart of the matter or checking out some online risk tolerance quizzes that offer a more in-depth look at your position.
Self-Assessment Questions
- How much of your portfolio are you willing to risk?
- Can you tolerate losing a significant portion of your trade?
- What is your experience level with options trading?
- How do you react emotionally to losing trades?
Risk Tolerance Quizzes & Tools
Check out some of the online tools available that can help you evaluate your risk appetite:
- University of Missouri—Investment Risk Tolerance Assessment
- New Jersey Agricultural Experiment Station—Investment Risk Tolerance Quiz
- Slavic 401k—Investment Risk Tolerance Quiz
- Carson Wealth—Risk Tolerance Quiz (Financial Advisors)
- Vanguard—Investor Questionnaire
- Michigan Educational Savings Program—Determine Your Risk Tolerance
Adjusting Your Strategy Based on Your Risk Profile
Risk tolerance can change over time because of life circumstances and your overall financial goals evolving. What this means for traders is that the amount of risk they’re willing to take on can fluctuate depending on a host of factors such as income, upcoming major expenses, age, or the time horizon before financial goals are met.
You might be at a stage in your investing experience where you must gradually move from a conservative to a more aggressive approach or vice versa! Newer investors who are younger have a much longer time horizon, so they have the ability to develop an aggressive trading approach. On the other hand, older investors have a shorter time horizon and might adopt more conservative trading approaches as they get toward the end of their work life.
Adjusting your strategy from aggressive to conservative (or vice versa) can be done through position sizing and using stop-loss measures to manage risk:
- Position Sizing: The process of deciding how many options contracts to buy or sell in a single trade. It’s based on each investor’s risk tolerance and available capital. It’s best to only dedicate 1-2% of your money to any single position. A more conservative position size would be 0.5-1%, while a more aggressive position size would be anything above 2%.
- Stop-Loss Measures: Automatic orders that trigger a sale when the security’s price reaches a certain level. Investors can scale these up or down depending on how much risk they’d be willing to take on with the trade.
Common Mistakes Traders Make with Risk Tolerance
Make sure you don’t make these common mistakes when determining your proper level of risk tolerance. Too many times, traders will overestimate or underestimate their risk tolerance, ignore the use of diversification strategies, or ignore the current market conditions. Don’t be someone who falls into their common trading blunders—take our advice and go forward with some useful insights on properly sizing your risk tolerance for each trade!
- Overestimating Risk Appetite: This occurs when a trader has assessed their willingness to take on risk as being higher than it actually is. It’s basically taking on trades that cause emotional stress. They make the mistake of believing they can tolerate more risk than they can realistically take on, which can lead to regulatory issues (depending on the industry), significant losses, or reputational damage.
- Underestimating Risk Tolerance: The opposite problem of overestimating your risk appetite is being too conservative and ultimately missing out on great opportunities. If you don’t go out on a limb every once, and a while with your trades, you could experience slower growth, or you might never grow your portfolio. Playing it safe all of the time, while prudent, is not a winning strategy for growing your investments.
- Not Diversifying Strategies: Relying too heavily on one type of trade is never a great idea in options trading. Having too much capital tied up in only a few types of trades can leave you vulnerable to market downturns, which could lead to significant losses. It’s best to invest a small amount in each trade and make sure that these investments are spread out across multiple industries and sectors.
- Ignoring Market Conditions: One key to successful options trading is to keep an eye on the market conditions and adjust strategies based on volatility and trends. Failing to do so can result in traders losing their investments when market downturns occur or missing the boat on trading opportunities by not pivoting to techniques that would benefit them in the current scenario.
Final Thoughts & Key Takeaways
Understanding and aligning risk tolerance with options strategies is important if you want to maximize potential profits and minimize potential losses. There’s something to be said for taking a conservative approach, especially when you’re new to trading options online or you have limited capital to work with. You might consider getting more aggressive with your approach once you gain more experience and you have the capital and time horizon to take justifiable risks to grow your investments.
It’s key to continually reassess your risk profiles as your experience grows. You might go from a conservative approach to a moderate approach or even an aggressive approach back down to a moderate approach. It all depends on your available capital and the time horizon to meet your goals. You can tweak your strategy with position sizing and stop-loss orders as well as you implementing the proper strategies befitting your skill level.
