- It’s a mad, mad, mad, mad market out there.
The volatility and utter unpredictability of the equity markets — and, by extension, the options market — can frustrate even the best and brightest traders.
If there was ever a time to be cautious with your trading strategies and to exercise the highest level of risk management possible, this is it. Of course, the great thing about the options market is that you can still make money no matter what the conditions are if you play it smart.
The rewards are there, and in some cases higher than ever before. But with high potential reward comes high risk. That’s why managing risk in a volatile market is a key component to coming out on the positive side of the ledger books at the end of the day, week, month and year.
So, how do you manage risk in a volatile options market? Here are 10 tips to help you do just that.
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Tip 1: Use Appropriate Orders and Trading Techniques
Never enter a market order for an options trade when the market is closed — you risk receiving an unexpected execution price. Instead, use a limit order.
And always enter multiple-leg orders, such as spreads and buy/writes, as a single trade. This will help reduce your commission costs and can help increase your chances of getting both legs executed at a favorable net price.
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Tip 2: Take Care of Your Multiples
For multiple-leg orders such as spreads and buy/writes, consider entering an order to trade at a price that is better than the market price (between the bid and ask). Then, if necessary, re-enter your limit order at the market price.
Often, the wider the bid/ask spread, the greater your chance of execution between the bid and ask.
When the spreads are wider, a market maker may be more willing to lower the ask or raise the bid in order to trade with you. When the spread is 5 cents or less, it will be more difficult to trade between the bid and ask.
One more thing: Limit orders between the bid and ask prices may more likely get executed in the last 15 minutes before the market close. Market makers may be more negotiable as they prepare to go home for the day.
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Tip 3: Spread Yourself Thin
Credit spreads can be a better strategy than uncovered (naked) options. Using a credit spread allows you to swap profit potential for the opportunity to reduce the risk.
But don’t make the mistake of thinking you have outsmarted the professionals. If the price of a trade looks too good to be true, it often is.
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Tip 4: Temper Your Expectations
Be sure you have a clear understanding of the risk/reward ratio for your trades. Don’t assume that a low risk/reward ratio is always a good trade. While the potential loss may be small, the trade may not make sense if losses will be incurred the majority of the time.
By contrast, some strategies with higher risk/reward ratios may be more likely to earn a profit, but when losses do occur, they could be significant. Always consider these factors before you trade.
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Tip 5: Covering Only Goes So Far
Don’t have a false sense of security about covered calls. Although covered calls establish a modest downside hedge, if the stock drops more than the premium of the option sold, your downside risk can be substantial.
This strategy isn’t for everyone. Writing covered calls can be a great way to add income to your portfolio, but if you aren’t prepared to let the underlying security go, then stay away from writing options.
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Tip 6: Set Targets Before You Aim
When trading equities, always set your profit/loss targets before you trade, and utilize bracket or stop orders when appropriate.
For stocks that are susceptible to gap opens, put options may provide better protection, albeit at a higher cost (protective puts increase your cost basis in the underlying securities).
Consider the factors in the following table before deciding the best way to help protect your equity position.
Three Strategies to Help Your Position
Stop order Stop/Limit order Protective puts Guarantees execution only Guarantees price only, not execution Guarantees execution and price until the expiration date of the put No costs if not executed No costs if not executed Costs money even if not executed Works well in slowly declining markets Works well in slowly declining markets Works well in slowly declining markets Halted or gapping markets may result in executions far from your stop price Halted or gapping markets may result in no execution of your order Works well in all types of markets, but costs more in volatile markets Requires equity position to be sold Requires equity position to be sold Does not require equity position to be sold Doesn’t lose value over time Doesn’t lose value over time Loses value over time
(time decay)
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Tip 7: Think Before You Act
If you’re a poor stock or direction picker, options will not likely make you profitable. Consider your opinion on the underlying security before establishing your options strategy.
It’s silly to throw your money around in the hopes of making a killing in the options markets. Your bottom line will be better served if you take some time to really understand the market and its underlying factors before you make investment decisions.
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Tip 8: Use Volatility To Your Advantage
Volatility can be your friend.
Consider selling in-the-money calls against some of your equity positions as a source of income and a partial hedge. When volatility is very high, option premiums are higher and in-the-money calls may generate more income than usual.
Keep in mind, however, that when you write covered calls, you’re foregoing all potential profitability above the strike price. Writing in-the-money calls increases the likelihood that your stock will be called away from you (sold at the strike price).
Consider selling out-of-the-money short puts on stocks you want to own, as a method for establishing new positions.
When option premiums are high, risk and the likelihood of assignment are both increased, but you can go much further out-of-the-money than usual and still potentially generate the same return.
By selling puts that are farther out of the money, the stock must dip much lower before you get assigned, then if you do get assigned, your cost basis will be lower.
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Tip 9: Opa! Learn Your Greeks
Take time to learn how “Delta” indicates the probability of an option expiring in the money, and you should use this measure to help you determine when to close your covered call position.
Understand time decay, or “Theta.” If your strategy involves buying long options, be sure to consider allowing plenty of time. If your strategy involves short options, consider trading months that are closer to expiration when time value erodes fastest.
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Tip 10: When In Doubt, Wait It Out
If you don’t have a good feeling about where the markets (or particular equities) are heading, there is nothing wrong with sitting on the sidelines.
Remember that perhaps the best tip of all is to refrain from trading at times. Patience is a virtue, as the old adage goes, so don’t hesitate to wait when the circumstances dictate.
