Options are financial derivative products that can hedge against risks from underlying trading. However, options trading has huge risks. If you want to succeed in options trading, risk management is a critical part. This article will take you to recognize the risks in options trading and do an excellent job in risk management.
Risk management techniques 1: Avoid market liquidity risk
Market liquidity risk mainly refers to the risk that options traders cannot hedge and close positions at a reasonable price due to the relatively low market trading volume. Even if a loss occurs, it may be impossible to stop the loss in time.
We can divide options into call options and put options, as well as different expiration dates and strike prices. Therefore, the number of different options for the same underlying security may be vast, and the trading volume of some contracts may be very low, resulting in the problem of inactive trading.
In the future market, the liquidity of the options is generally lower than those of the underlying futures. In the stock market, stock options are much less liquid than underlying stocks.
Netflix Inc (NFLX) options (call options expiring on December 23 with a strike price of $285), shown in the figure, have only 46 units in volume. The feature of options trading is that contracts near par are more active. Rare people trade deep-in-the-money options and deep-out-of-money options, or even no one cares about them.
Over time, if the underlying price deviates farther from the execution price of the options held by investors, the options will gradually become inactive in the market or even unable to be traded. Investors may be unable to close their positions in this situation.
Solution: When investors buy options, it is best to choose underlying options with better liquidity. Generally speaking, the more liquid the underlying, the more liquid the options will be. For example, Tesla Inc’s stock (TSLA) is one of the most active stocks in the market, so TSLA’s options are also very active. The trading volume of its options even exceeds that of many stocks.
Risk management techniques 2: Pay attention to risk of loss of time value
For an option buyer, as the contract expiration date approaches, the option’s time value will gradually decrease. When the expiration date comes, the value of the out-of-the-money options and the in-the-money options will gradually return to zero. Because its intrinsic value is zero, and the time value gradually decreases to zero too. In this case, the buyer will lose all the premiums when the option expires.
Investors need to realize that although the buyers of the option have the right, this right has a time limit. Suppose, within the specified time limit, the market volatility fails to meet expectations (for example, the stock price fails to rise above the call option’s exercise price or fall below the put option’s strike price). In that case, their options will lose all value at expiration.
Even if investors are correct about the market trend, if the underlying starts to rise after the option expires, it will not help at all.
It is easy to see that the risk of loss of time value is related mainly to the options’ expiration dates chosen. Investors should combine their market expectations and specific options trading strategies to select a reasonable expiration date when trading options.
Unlike stock trading, one of the essential characteristics of options trading is that it has a limited life cycle. Many investors in the stock market often wait after the stock is tied up, hoping the stock price will rise again one day. The cost of such an operation in the stock market is time, while the cost may be losing all the premiums in options trading.
Solution: Whether you are the buyer or seller of the options, you should not hold the mentality of not closing the position. Once you find the market analysis is wrong, you must decisively stop the loss and close the position. The buyers can recover part of the premiums, and the sellers can also avoid further expansion of losses.
From another perspective, investors should not wait for the expiration after holding an option position. Still, they should pay close attention to, analyze the market trend on time, and rationally adjust investment decisions when necessary.
Risk management techniques 3: Do not overlook implied Volatility risk
In options trading, we should also pay attention to the impact of implied volatility, an important aspect that differs between options and stock trading. Implied volatility can be used as an essential indicator to measure the price of an option. The higher the volatility, the higher the value of the options. Options buyers may suffer losses due to the reduction in implied volatility even if they buy in the right direction. The implied volatility of options will rise sharply before some critical economic data or companies release financial reports. If you buy options at that time, and then the stock price does not fluctuate significantly, even if you predict the right direction, you will still lose money because of the reduced volatility. Because after the data or earnings report is released, the implied volatility will drop sharply again, resulting in lower option value.
Solution: Investors should focus on both the option premiums and the implied volatility. As a buyer, it is best to buy options when implied volatility is low. On the contrary, as a seller, it is best to sell options when the implied volatility is high. These will be helpful to increase the probability of making a profit in trading.
Risk management techniques 4: Make protection for premium risk
The price of an option is premium. The maximum risk for the option buyer has been determined, and the maximum loss is the premium. However, options sellers face risks and losses of great uncertainty. Especially for those who sell call options, if the underlying rises too much, it will cause huge losses. The maximum loss of a call option seller is theoretically unlimited.
Solution: As an options seller, the profit is limited, but the upper limit of loss is high. Therefore, it is best to hold specific underlying securities or buy call options with a lower strike price for protection while selling the call options.
This article introduces four risk points of options trading. As a highly leveraged financial derivative, options can bring us high returns if we can use them well. However, high returns correspond to high risks, and both option buyers and sellers should do an excellent job in risk management. Options trading is far more complicated than what I write here. Many factors affect options prices, including underlying price, strike, remaining time, volatility, risk-free interest rate, dividend rate, etc. All the factors mentioned above will generate the risks of options trading. If you want to learn more about options trading, you can visit Canny Trading.