Most new traders think they’re playing it safe. In reality, they’re walking into risk blind.
We consider understanding risk in options trading more important than understanding the potential reward. Many traders or investors enter options trading with little regard for managing risk, which can result in many smaller, unnecessary losses that build up over time or big losses that come from ignorance or disregard for factors like volatility or being overleveraged in their investments.
Our guide will break down the most common misconceptions and provide a clearer, more realistic view of managing risk. We’ll address the primary differences between probability and possibility in options trading, how to make sure you’re not overleveraged in your trading strategy, and how to effectively take implied and historical volatility into account. Basically, we’ll address each and every form of risk in options trading and how to correctly understand how to manage these risks so you can experience minimal problems while trading online options as a newbie.
The Illusion of Limited Risk with Options
The common myth when it comes to options trading is that “options limit your downside.” The maximum loss you could incur on an options contract is indeed the premium you pay to enter the trade, and there are certain strategies where options can be used to limit your risk. It’s key to note that there are individual contract limits that come with single options like calls or puts. In these cases, the most you’re going to lose is the premium paid to enter the trade.
However, the misconception with this idea comes from the fact that it implies all options contracts are risk-limited. There are some strategies that technically come with unlimited losses, so the idea that “options limit your downside” isn’t completely true.
Selling Calls or Puts
Selling options can come with unlimited risks, and it’s a good example of the idea that options don’t always come with limited risk profiles. For instance, traders can incur large losses if the stock price falls significantly when they are selling put options. This is due to the trader having to buy the underlying stock at the strike price if the stock price drops below that strike price.
There are ways for traders to limit risk strategically using options, as we mentioned earlier. A good showcase of this concept is the protective put where you’re buying a put option of a stock you already own to act as an insurance policy against the stock price experiencing downside movement. Though it can limit risk with an investment, you still have to pay a premium to set up the protective put, and this could be a potential loss if the stock price stays the same or goes up.
Callout Example
Buying cheap out-of-the-money calls is a good way to keep your overhead low going into the trade, but the likelihood that these trades are going to produce a profit is highly unlikely because there needs to be a big move in the price of the underlying asset. The premium paid to enter the trade is the maximum loss that traders can experience with this position, and it happens if the underlying stock price doesn’t rise enough by the expiration date.
Misunderstanding Probability vs. Possibility
New traders often confuse what can happen with what is likely to happen. The issue with confusing probability and possibility is the fact that they both relate to events that might occur, but they measure the likelihood of those events in two different ways. The best way to illustrate this concept is that it’s possible to win money playing a slot machine, but the probability of doing so is limited to a certain percentage, usually the return-to-player rate.
The Difference Between Probability and Possibility
Possibility refers to the general state of something being able to happen, while probability is a measure of how likely an event is to occur. Possibility is the indication of whether or not an event is logically conceivable or not. On the flip side, probability quantifies how likely an event is to happen, usually characterized as a percentage ranging from 0% to 100%.
Understanding Delta
In options trading, it’s possible to use the Delta Greek as a proxy for probability, specifically how likely an option will expire in the money. The value of Delta can be seen as an approximate percentage chance that an option will be ITM by the expiration date, though it should be taken as an absolutely perfect representation. Delta is often overlooked by traders and investors as being used for this purpose.
When it comes to call options, a positive Delta indicates a higher probability of the call expiring ITM. If the Delta, for example, was 0.5, this would indicate that the option’s price will likely go up $0.50 for every $1 increase in the underlying asset’s price. When it comes to put options, a negative Delta can suggest that there’s a higher probability of the put option expiring ITM. If the Delta for the put option was -0.5, this means that the price for the option would decrease by $0.50 for every $1 increase in the underlying asset’s price.
High-Reward Trades Can Have Low Probability
Trades that promise a high reward to the trader or investor could have a low probability of being profitable. The odds of winning can be extremely slim, even though the potential payoff could be quite significant. A good example of this would be buying deep out-of-the-money options that can help traders secure a hefty profit, but it rides on the underlying asset price moving significantly, which has a low probability of occurring.
You could see it in terms of betting money on a long shot in a horse race. There’s a low probability of the horse winning that particular race because they have tough competition, making it unlikely that they’d come out victorious on the other end. However, the payout could be significant;y higher for the gambler than if they bet on the horse that’s likely to win. Just because the reward is higher on the long shot, the probability of that horse winning the race is a lot less likely.
Overleveraging without Realizing It
Something important to know about options is that they offer built-in leverage — they let traders use call or put options to seek returns on certain amounts of stock with less than purchasing the stock outright. This can be dangerous when not respected, as traders can often get themselves into a situation where they are overleveraged.
What does it mean to be overleveraged?
This refers to using a large amount of borrowed money (also known as leverage) to enhance your trading positions. By risking more capital than you own, traders could possibly experience higher profits if they get their trades right, but there’s also the possibility of incurring bigger losses too. Being overleveraged in options can technically work for some traders (usually those with more experience and better market timing), but it can backfire.
A small capital base can be wiped out with poor trade sizing. This happens quite often when traders risk more capital than what they actually own. There are a few ways that traders can stumble into a bad pattern of overleveraging without even realizing it:
- Not adjusting position size based on account size
- Risking too much premium relative to capital
- Ignoring maximum loss scenarios
Ignoring Volatility Risk
Another major mistake that online options traders make when it comes to risk is ignoring volatility, both implied and historical. Many times, newer traders with little background experience will focus on market direction alone and don’t take volatility movement into consideration. The truth is that rising and falling volatility can have a profound impact on long and short positions alike.
Implied and Historical Volatility
New traders should take both implied and historical volatility into consideration, in addition to tracking the possible future directions of the market. This can give them a good idea of the risks that might come from market volatility and how it could potentially impact the stock prices. Knowing the difference between the two metrics can give traders a complete understanding of the volatility picture, helping to inform future trading strategies or risk management practices.
- Implied Volatility—The measure of the market’s expected future volatility of an underlying asset which is ultimately reflected in the options price. It’s an indication of the market’s belief about how much the price of the underlying asset will change or fluctuate before the option contract’s expiration date hits.
- Historical Volatility—Unlike implied volatility, historical volatility is a backward-looking measure that shows how much a stock’s price has fluctuated over a certain span of time in the past. It allows traders to understand the potential risks that come with the stock, rooted in its past price behavior. Historical volatility is a useful tool to help inform a future trading strategy.
Example of Taking Volatility Risks into Consideration
A decent way to illustrate how looking at volatility can inform a trading decision, let’s look at an example of a trader buying call options ahead of a key earnings announcement with an already inflated IV. What this basically means is the trader is making a bet that the stock price will rise before the earnings announcement, which is a great move considering that a rise in implied volatility usually results in stock prices going up as well.
Along with using implied volatility as an indicator of what might happen going into the earnings announcement, traders should also use historical volatility as a way of confirming the trend they believe is about to happen. Traders using historical volatility can take a look at the volatility levels of the same stock around the time of earnings announcements to get an idea of how the price reacted to the event. Not only can this be confirmation of the strategy they’re using for the current situation, but traders using historical volatility to back up their prediction can also get an idea if an IV crush is likely to occur coming away from the earnings announcement.
Underestimating Assignment & Liquidity Risk
A few other factors that can create potential risks for options traders are assignment risks, the liquidity of each options contract, and slippage, which happens when market fluctuations create situations where trades will execute at different prices than what the trader was expecting. It’s key to know how these risks can impact your trading plan, and we’ve outlined them below in great detail to help you understand what you could be up against when selling options.
Assignment Risks
When writing options, traders take on an obligation to fulfill the terms of the contract if the buyer exercises their right to buy or sell the underlying asset. When the buyer exercises their right, this means that the seller is under obligation to sell the underlying stock at the strike price with a call option or to buy the underlying stock at the strike price with a put option. If traders aren’t considering assignment, there’s a chance that they don’t have the money on hand to fulfill the obligation of their option contract.
Early Assignment
Many new traders don’t realize early assignment is possible, which occurs for various reasons including how in-the-money the options happen to be before the expiration date occurs, option holders exercising contracts early to capture dividends, or traders using early assignment to make it easier to borrow money for short selling.
Liquidity in Options
Liquidity refers to how quickly and easily an options contract can be bought or sold. Liquid options are those that can be traded quickly and with ease, and it doesn’t have a profound impact on the underlying asset’s price. Options contracts that are in high demand have higher liquidity, while less liquid options are characterized by little interest from investors because they don’t have as much value or potential to be profitable. This leads to little demand for contracts like these.
Liquidity Traps
A liquidity trap refers to a trade that looks desirable because of its lower premium, but one where the bid/ask spreads are wide (which indicates lower liquidity). Inexperienced traders can stumble into these traders thinking they’re getting a deal, but it’s a position that will be hard to sell at a profit without affecting the underlying asset price.
Slippage
Slippage can crush your edge or unexpectedly increase risk—it happens when the trade is executed at a different price than you originally anticipated. This can happen if your broker app or the device you’re trading from doesn’t have the fastest execution speed which can result in the trader executing at a different price if there was a market fluctuation during the time you finalized the trade and the time it took for it to process.
Emotional Risk: The Hidden Killer
Another considerable risk for traders to keep in mind has nothing to do with the market factors that are out of their control but everything to do with their mindset and the trading routine they develop over time. We are referring to the risks that come from emotional trading decisions.
Options trading requires logic, rationality, objectivity, and an approach that’s rooted in a trading plan. When you begin letting your emotions dictate what you’re doing, you can run into trouble. For instance, the fear of missing out can lead some traders to take on too many positions and putting them in a place where they’re overleveraged. An emotion like frustration could possibly lead traders to double down on losing trades to recoup the money they lost in a bad trade.
Risk isn’t just numbers — it’s how you respond to losing or winning trades. This is the importance of having a trading plan and sticking to it. Giving way to emotions can cause you to stray away from the principles of your plan and make decisions that could result in further losses. Sticking to your plan will likely have you cut losses early and simply move on to the next strategy.
The Right Way to Think About Risk
Risk should be calculated, planned for, and respected. The best way for traders to make managing risk a top priority during their online options trading sessions is to use risk-defined strategies and work into tools and practices that prioritize risk management.
Risk-Defined Strategies
Risk-defined strategies for beginners are a great place to begin if you’re interested in planning for the potential risks and calculating the risks and rewards associated with each position you take on. A few examples of these strategies include the following:
- Iron Condors—The maximum profit is the net credit received, and the maximum loss is limited by the range of the strike prices minus the net credit.
- Covered Calls—The risk of the covered call is the cost of the shares minus the premium received. The maximum profit potential is the premium received along with any increases that come with the stock price.
- Long Straddles—The maximum profit potential is unlimited (if the stock prices move significantly in either direction), and the maximum risk is limited to the premium paid for both options.
- Debit Spreads—The maximum profit with the debit spread is capped at the difference between the strike price minus the debit paid. The maximum loss a trader can incur on these trades is limited to the net debit paid.
- Credit Spreads—The maximum profit for the credit spread is capped at the net credit the trader receives for putting together the trade. The maximum risk is limited to the difference between the strike prices minus the credit received.
Tools and Practices to Improve Risk Management
Traders who want to effectively monitor and manage the risks that are present with their positions should work these tools and habits into their trading practices.
- Strategy Builders—Strategy builders are great for pinpointing good opportunities or potential threats and providing a good framework for a trader’s plan and goals. Use these online tools to begin analyzing, developing, and implementing trade strategies to build capital and to effectively monitor/manage the risk along the way. Try out our AI-powered Options Strategy Builder for free.
- Options Profit Calculators—When traders can map out each trade by knowing the profit and loss potential upfront, they can form a sound plan to secure profit through strategic trading, which brings in small gains over time. By using these options profit calculators, traders can estimate the potential profit or loss through factors like strike price, expiration, asset price, and market conditions.
- Trade Journaling Apps—Keeping track of all trades, including the strategies used, profit and loss, time of day, and anything you were feeling while executing the trade, can offer traders key insights into what they’re doing right and what could be done differently for better results. While you can keep track of what goes on in your trading sessions on paper, there are trade journaling apps where you can record all of your trading activity for later analysis.
- Paper Trading Platforms—These demo accounts can let you gain experience and familiarity with the options market and how to maneuver correctly using the right strategies and risk management principles. While journaling your trading activities is great for improving your trading skills over time, paper trading simulators have proven to be highly effective, letting you run through different trading strategies or techniques without having to risk your own money.
Rethinking Risk Is the Real First Step
Most new traders focus on profit potential — the pros focus on risk. If you want to last in options trading, start by asking: How much can I afford to lose? Traders who focus their efforts on minimizing the potential losses over time will generally find themselves with more money in their accounts, while also employing low-risk strategies that generate predictable, steady, smaller returns that allow for incremental growth.
Risk isn’t something to avoid — it’s something to master. Avoid overleveraging yourself by taking on fewer trades, using the correct position size, and focusing on the quality of each investment or the quantity of how many you’re dealing with. It’s also key to keep volatility, liquidity, assignment risks, and slippage in mind. Remember to stay in a logical and rational frame of mind by sticking with your trading plan to avoid slipping into emotional trading habits.
Frequently Asked Questions
We’ve outlined several questions from our readers and customers about risk and what newer traders get wrong when it comes to this aspect of options trading. Check out our answers to these questions. You can get a lot of the key highlights we discussed in this guide without having to read the entire thing!
What’s the Biggest Mistake New Traders Make With Risk?
We’d say that the biggest mistake for new traders is that they fail to understand the proper risk management techniques and they don’t work them into their options trading practices. Having no trading plan in place means that you’ll make the mistake of emotional trading, risking too much capital on each position, and not keeping track of how much capital you’re making or losing on each trade.
Are There Truly “Safe” Options Strategies?
There are some strategies that are considered less risky, but all options trading come with some form of risk for investors. No strategy can guarantee profits, but there are some that are better at doing it than others, like the credit spreads or covered call strategies.
How Much Risk per Trade Is Reasonable?
Our general recommendation is to not risk any more than 1-2% of your available capital on any given position. This can keep your losses to a minimum, where you’re not blowing through a whole lot of money if you end up being wrong about the direction of the market, the level of volatility, or what have you.
How Can I Tell if I’m Taking on Too Much Risk in a Trade?
If your position size is any more than 2% of your total capital, you’re likely taking on too much risk in the trade. Another classic sign is that you don’t have the money on hand to fulfill your obligations if the buyer of the options contract exercises their right to buy or sell the underlying asset.
What’s the Best Way to Balance Risk and Reward as a Beginner Options Trader?
Traders, regardless of their skill level or background experience, should only take on a trade if the risk-to-reward ratio is 1:3. To calculate this ratio, divide your net profit (the total amount of money you keep after subtracting all costs and expenses) by the price of your maximum risk.
