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Risk Management for the Options Trader

Here at Good Kids Trading, we primarily trade options. Options come with their own risks which, when appropriately mitigated, are far outweighed by the benefits of trading them. Regardless of whether you are trading stocks, options, crypto, real estate, or literally any other asset class, you should have a full and complete understanding of the risk involved before you dive in. This article outlines the basics for how we at GKT view and manage the risks involved with options trading. Keep in mind that the beauty of options is that there are endless ways to manage a position, and there frequently isn't one "right" way to do things.

Is Options Trading Risky?

Now this is a LOADED question. The short answer is definitively, "Yes!" The long answer is, "Yes, but..."

Crossing road risk analogy

To begin with, we need to address the concept of risk being relative. Using an everyday example, crossing a street is generally speaking an activity that carries risk of getting hit by a car. If that street happens to be an interstate the risk of getting hit is significantly higher than you crossing the street at the end of a cul-de-sac.

In the context of options, the main factors which help put the risk into a better perspective is the underlying, the strategy, and the position size.

  1. Underlying - The term "underlying" is a general term which references the stock or ETF that is being traded.

  2. Strategy - Another broad term which paints a picture for how an option or a set of options is to be used. Using a sports analogy, man coverage and zone coverage are two strategies for playing defense.

  3. Position Size - How many options contracts, and ultimately dollars, are being risked on that given trade? This is best considered by using a percentage of your portfolio's value. $1000 is 10% of a $10,000 portfolio.

Relative Risk in the Underlying

The reality here is that every asset class has a perceived risk. The risks that come with real estate are much different than the risks that come with cryptocurrency and the risk is nearly impossible to quantify. There is no simple measure that says real estate is worth 2 risk units and crypto is worth 5 risk units. However, most people would generally agree that real estate is less risky than cryptocurrency. The more specific you become with this analogy, the more impossible the comparison becomes. Is a class D property in some major metropolitan downtown district more or less risky than Dogecoin?

The risk becomes more easily quantifiable when you compare two different assets within the same asset class. For you and me trading the stock market, there is an easy way to answer the question, "Is TSLA more risky than KO?" and it comes in the form of Beta.

Beta Approximates Risk

Beta measures how much the underlying moves in comparison to "the market," typically the S&P 500. If every time S&P 500 moves the underlying of interest moves twice the amount in the same direction, the beta will likely be >1. If it moves less than the S&P 500, then it will be <1. Investopedia has a phenomenal article discussing how beta is calculated if you want to go down that rabbit hole.

For the purposes of this article and how we at GKT trade, knowing the beta helps us approximate how much risk, relative to the S&P 500, the underlying carries. In a portfolio full of high beta underlyings, you should expect larger swings in your account compared to a portfolio of low beta underlyings. Just like most things, there is no right or wrong amount of beta to carry and there are certainly pro's and con's of having more or less beta. As you develop your style and risk tolerance, the beta will generally fall into place. Beta values for can be found readily on sites like Yahoo Finance.

Risks of Different Option Strategies

There are literally hundreds of text books, thousands of blogs, and millions of hours of video on YouTube discussing the nuances of the endless different strategies that can be employed with options. We at GKT keep it simple and believe in the importance of knowing the basics. Once you understand the principles of buying versus selling options and defined versus undefined risk strategies you can apply these concepts to match your individual risk tolerance. Before going any further, one thing that should never be forgotten is that if you let an option expire in the money, SOMETHING will happen to your account.

Buying Options

Just as when you buy food at the grocery store, you spend money and get something in exchange. You know exactly how much you spend upfront. With options it is the same thing. When you buy a put or a call, you pay money up front for them. This is commonly referred to as "paying a debit," or simply a "debit." The debit paid almost always represents the maximum amount of money that can be lost.

Paying a debit for an option

Option buyers have an underlying belief that something will happen. For instance, XYZ is currently at $100 dollars in January and Jack sees that the $110 Call for February for a premium of $2.00. Jack ends up buying this call because he believes XYZ will be above $112 ($110 plus the $2.00 debit paid) at expiration in February. In strategies where a debit is paid, the underlying assumption is that something will happen to the underlying and that assumption must occur in order to be profitable.

Selling Options

Unfortunately selling options is slightly more complicated than buying options. Option sellers believe something will not happen. Using the example above, Jill thinks XYZ will not go above $110 in February. In fact, Jill sold the $110 February Call to Jack. The debit Jack paid goes directly into the pocket of Jill and is termed a "credit." In order for Jill to be profitable, XYZ would have to be less than $112 at expiration. But what if it there is an unexpected buyout on Jan 31st and the stock rallies to $200 at expiration? Well, Jill would be now down $88 per share (Current price of $200 minus sold strike of $110 minus credit received of $2.00), or $8800 per option contract since each options contract is for 100 shares of the underlying.

Option sellers get paid the premium to cover the risk of the unknown. The buyer has to pay for the certainty that they can only lose as much as they paid. The premium associated with an option is directly related to the perceived risk of the stock. A stock with higher perceived risk, represented by beta, tends to have more expensive options.

Undefined Risk Strategies

Any option strategy that has an uncovered sold option will always have un defined risk.

Selling a call or a put is the simplest undefined risk strategy. Selling just the call or put, without anything to back it up, or cover it, is referred to as being naked. If you don't own stock and sell a call, it is call a "naked call." If you own 100 shares and sell a call it becomes a "covered call." With puts, if you have enough cash to cover being assigned the shares, it is called a "cash-secured put," and if you don't it is a "naked put." If you want to be really technical, a naked put has defined risk in that a stock can only go to $0. If Jack sold a put on XYZ at the $100 strike and the next day the company files for bankruptcy and goes to $0.00, Jack can not lose any more than $100 per share. However, because XYZ can theoretically close at any price below $100, the risk cannot be specifically identified, which is why only selling a put gets lumped into the undefined risk category.

Example of a naked put
Example of Selling a Naked Put

Risk Defined Strategies

The most simple risk defined strategy is buying or call or a put. The debit paid is the the maximum amount that can be lost. If anyone were to ask Jack how much he was risking on his XYZ trade he could with 100% certainty tell them $200 ($2.00 per share multiplied by 100 shares).

Option strategies with multiple legs that result in a debit all will have defined risk. (An option leg refers to the individual calls or puts bought in more complex strategies. For instance, a strangle has 2 legs, an iron condor has 4, and credit spreads have 2.)

There are also risk defined strategies that result in you receiving a credit. The most simple version of this is a credit spread. Regardless on if it is a put or a call credit spread, the basic set up is selling an option and then buying another one just a little bit further out of the money. An example could be Jill selling the $100 call and buying the $105 call when XYZ is currently at $95. This setup would result in you receiving a credit, lets say of $1.50. In this scenario Jill wants the stock to stay below $100 to receive the maximum profit. If we imagine the worst case scenario and at expiration XYZ closes at say $150, Jill would have only lost $3.50 per share instead of the $50 per share if she just sold the $100 call.

In short, if a call or a put is sold, and another option is purchased slightly further out of the money, then the risk for that trade can be calculated and therefore is defined.

A call credit spread is a defined risk options strategy
Example of Selling a Call Credit Spread

If this concept is new to you, let me break this trade down in detail. At the beginning Jill believed that XYZ would not be above $100 on the expiration date. By selling the $100 call, Jill becomes obligated to sell shares to someone at $100 if the stock closes above $100 at expiration. Jill was uncomfortable with the undefined nature of this trade so she defines her risk by buying the $105 call. This second call she purchased is cheaper than the call she sold, resulting in a net credit. The $105 call she bought allows her to buy shares from someone else, even if the price of XYZ is lets say $200. In our fictitious trade, XYZ closed at $105.01. Because of this close, Jill was obligated to sell 100 shares at $100 and then bought 100 shares at $105. This resulted in a $5 per share loss. Recall she made $1.50 in credit at the beginning of the trade which means she only lost $3.50 per share on the trade. If she did not have the call at $105 and she bought 100 shares the second before the market closed, she would have lost $3.51 per share. The higher Jill has to buy shares to cover the naked call, the greater the losses.

Position Size Affects Risk

This principle is simple and straight forward. At GKT we intentionally keep position size small. The overall principle we subscribe to is that we want to keep our trades so small that even if we take max loss on a defined risk, or a large loss on an undefined risk, we won't blow out our account or even lose sleep at night. If you are checking the market every few minutes and following the pre and post market action willing the stock to move in a direction, the position size is too large.

"Small," is a relative term and is directly related to account size and trading experienced. As a general guideline, risking about 1-2% of your account size per trade is a good place to start. If you are brand new with a smaller, 0.5-1% may be more appropriate. At the end of the day, your emotions will help you fine tune your position sizing.

We keep our position size small in order to avoid trading emotionally. Emotional trading will cause you get get out of a trade too early, hold a trade for too long, enter a trade before you get a complete signal, or any number of other things. This is why we set up GTC orders once we enter our trades. It takes away the emotion of when we exit the trade! The nuances to this all depend on your trading style.

Risk Management for the Options Trader

Putting this all together, options trading is risky but the risks can be mitigated. Start by choosing an underlying that meets your risk tolerance. Then find a strategy that you know well and fully understand and only trade a small position size. Finally, repeat this process so that you have several different trades on at the same time. Taking trades on different underlyings with variations in strategies and directions creates diversity. This diversity guarantees that you will have some winners, some losers, and some trades that just need more time. The winners will hit their GTC orders and close out. Now you get the chance to manage the losers and let the other trades play out.

Keeping position size small ends up being the key to this whole process. Small position sizing allows you to be systematic at managing your losers and capturing profit on your winners. Small position size allows you to take more trades which increases your chances of having winners. It helps you take a new trade after realizing a small loss. Small position size allows you to keep the machine going.

At GKT we practice these concepts every day. Plus, trading in a community of likeminded people is far more fun, educational, and profitable! Join our discord today:

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