Risk Management for Option Traders

by Mark Wolfinger | May 1, 2010 3:51 am

Risk Management for Option Traders

 

We all want to earn profits, and when you do, it’s natural to believe you have become a star trader. However, it’s a fact of life that even the most skilled traders run into periods in which luck plays a big role in their results. Sometimes it’s a winning streak, and other times, it’s a losing streak.

The experienced trader recognizes that these streaks are inevitable, and may decide to take a break from trading after a few setbacks, even if it’s only a day or two. The less skilled trader is oftentimes anxious to continue trading in an attempt to recover recent losses.

However, streaks come to an end, and for the majority of our trading lifetimes our results are determined by our skill set. At the top of the list for successful traders is the ability to manage positions, which includes managing money and managing risk.

Too many beginners get fixated on finding just the right strategy — the one that earns profits on a regular basis. These traders are not wrong to search for a strategy that makes them feel comfortable, but far more important to their long-term success is their ability to manage risk. They will discover that it’s not the strategy that brings profits, but the proper management of risk associated with that strategy.

Traders find it easy to enter into a trade. After all, isn’t a trade just another opportunity to make money? Yes, it is. But if that trader doesn’t see the danger of losing money on that trade, then he or she is going to get careless. The result can be an occasional big loss[1] — say a loss large enough to wipe out a year’s worth of profits. The skillful risk manager never allows that to happen.

Risk management involves limiting risk. It requires the trader to recognize when a trading idea is not bearing fruit and that it’s time to exit the trade[2]. It requires knowing when a position with acceptable risk has turned into a position with high risk due to a change in market conditions. Stubbornly refusing to make an adjustment to the position, or exit the trade, the poor risk manager holds hoping for good luck.

The difficult part of this scenario occurs when that good luck is found. The market settles down, the position recovers and the trader takes the profits. Lesson learned: None.

Sure enough, the next time the trader gets into trouble and good risk management requires that something be done to reduce the trader’s exposure to loss, once again the strategy of “hope” is adopted. This time, it’s bad news. The loss increases, the trader gets more stubborn, and incurs a major setback. This is not the path to long-term success.

I encourage all traders to love profits, but to understand that taking prudent losses is a necessary part of the game. Preventing large losses is essential if you want to have a lengthy trading career.

There are many aspects of risk management, but the easiest principle to apply is to size positions correctly. That means trading an appropriate number of contracts to guarantee that your worst-case scenario doesn’t hurt your account or your ability to continue trading.

It’s very tempting to increase the size of your trades, especially when you are making money. That’s a big mistake. It’s a good idea to know whether you are doing well because you are taking the right steps, or because you are experiencing favorable market conditions. In other words, good luck.

Only after you are sure you understand risk and reward, and how to manage your trades well, is it time to think about increasing size. Be careful.

There are many other variables that must be mastered to become an accomplished risk manager, but rest assured that just because you are making money now, does not mean you are going to succeed. Paying attention to risk is part of your job as a trader.

Tell us what you think here.[3]

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Endnotes:
  1. occasional big loss: http://www.optionszone.com/options-trading-101/getting-started/risk-of-ruin-a-common-trading-mistake-that-could-ruin-you.html
  2. exit the trade: http://www.optionszone.com/trading-ideas/gallery/when-to-exit-an-options-trade.html
  3. Tell us what you think here.: mailto:editor@optionszone.com
  4. 10 Tips to Manage Risk in a Volatile Options Market: http://www.optionszone.com/trading-ideas/gallery/10-tips-to-manage-risk-in-a-volatile-options-market-part2.html
  5. A Common Trading Mistake That Could Ruin You: http://www.optionszone.com/options-trading-101/getting-started/risk-of-ruin-a-common-trading-mistake-that-could-ruin-you.html
  6. Managing Risk Using Options: http://www.optionszone.com/learn-more/randy-frederick/managing-risk-using-options.html
  7. Get their names here.: http://www.optionszone.com/order/?sid=CW3246

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