Risk management

There’s something about the deceptively low price of some options that can lure some new traders into buying too many at once. After all, the maths is so simple. If you have just $2,000 and a call option costs $2, you can afford to buy 10 calls, right? Whoa, pump the breaks.

Technically, yes, you can afford the transaction but if the extent of your trading plan is shooting from the hip your trading days are likely numbered.

When you’re in a position, there are too many things outside of your control to keep track of, so let’s focus on the things you can better control. One of them is risk management. You have the most control over your risk the moment before you place the trade.

Think of your trading account like a business, and your role is the Chief Risk Officer. Now, let’s activate our spidey senses and come up with a plan to help protect our capital (that’s CFO speak for cash).

The amount of information out there about risk management and trade planning could fill volumes of books (trust us, we’ve read them). But it boils down to asking yourself a few critical questions:

• What will I trade?
• What strategy will I use?
• How much capital should I risk?
• When do I get in?
• What do I do when things go wrong?
• What do I do when things go right?
• When do I get out?

Get in the habit of jotting all this down in a trading journal before every trade, and update the journal with your results. Then, rinse and repeat. We’ve covered some of these bullet points in other articles, so let’s focus on two: what to trade, and how much capital you should risk.

One of the single most important decisions when trading options is selecting an underlying asset (stock, ETF, etc.) to trade. It’s usually the first pitfall new traders come across in their trade selection process. Now, we can’t tell you what to trade (it’s against the rules), but we can share some information to help you find one that’s appropriate for you. While we can spend an entire article on this (and we will), here are some crucial things to consider:

1. Trade underlyings with good liquidity. Liquidity is the ease with which you can get in and out of a position. This can usually be spotted when an underlying stock or ETF has a tight “bid/ask spread,” and at least a million or more shares traded per day (unlike some “penny” stock you heard about on an online forum. Spidey senses activated).

2. Trade options with great liquidity. If the underlying is more liquid, the options tend to be as well. Options with good liquidity usually have tight bid/ask spreads (i.e. 1.00 bid x 1.01 ask; 2.25 bid x 2:30 ask; 35.50 bid x 35.80 ask) and plenty of volume (contracts traded) and open interest (contracts open).

What does an illiquid option’s price look like? .50 bid x 4.25 ask; 1.00 bid x .5.25; .05 bid x 5.00. If an option is 0 bid (zero bid), this means at the moment there are no willing buyers for this option. So if you see 0.00 bid x 5.00 and you pay 5.00 or less for that option, you will have no one to turn around and sell it to. You can get into the position, but you can’t get out unless someone places a bid to buy the contract. Illiquid options are like the Hotel California: You can check out anytime you like, but you may never leave.

3. Trade underlyings you’re familiar with. Stocks are like fingerprints - their patterns, movements and identities are unique. Trading options on a stock you’re not familiar with is like walking into a dark room you’ve never been in and trying to draw your surroundings. Get to know a stock before you commit. Keep your watchlist small at first. Avoid products that are too complex, like triple-levered this, and inverse that. Options are complex enough. There’s no need to introduce unnecessary risk into your portfolio.

When you’re ready to place a trade, this is the million dollar question. Because, in trading, your capital is everything. In fact, it’s the only thing that matters at the end of the day. If you don’t have capital, you can’t trade.

For the most part, your goal isn’t to just win. Your goal is to lose less than you win. Another way traders phrase this is, “It’s not about how much you make, it’s about how much you don’t lose.” Losses are inevitable, so controlling how much you could lose before you enter into a trade could be the single most important decision you make before each trade.

Determining how much capital you put into each trade is called “position sizing.” And the first thing to think about is how much of your capital you’re willing to lose. What if you lose five trades in a row? What if you’re completely hexed and you lose 10 trades in a row? No matter what happens, preserving your capital to make it to another trade is your first goal.

So, how much is just right? That’s up to you. But, for starters, putting all of your capital into one trade on something like long calls may not be a viable, long-term strategy. You might get lucky and make money at first, but if that’s your trade management strategy, eventually what the market giveth, the market will taketh. Take it from veteran traders, you’re only as good as your last trade.

Position sizing comes down to a couple of things - how much you have, how much you’re willing to lose, and some maths. None of these are arbitrary, but they don’t take rocket science to figure out, either.

You should already know what you have, so how much you’re willing to lose is more of a gut check.

Is risking 100% of your account on one trade a bad idea? Probably. But what about 10%? How about 5%, or 2%? Check your pulse as the numbers go down and imagine losing that amount. Let that sink in, it’s important. If you lost a certain percentage of your account on one trade, is that a loss you can absorb?

If 10% is too hot, and 2% feels too cold, but 5% feels just right, lock it in your plan and promise Goldilocks you’ll never break your “5% rule” again. (Not a recommendation here, simply for illustrative and educational purposes. It is up to you to gauge and consider. Actual values will vary.)

From there, the maths with options is simple.

Sizing up a long option trade: If you’re trading a buy strategy like long calls and long puts or debit spreads, it’s the cost of the trade divided into your total risk per trade.

For example, if Savvy Savannah has $10,000 in trading capital and applies the 5% rule, that’s $500 in max risk per trade. If the price of an option is $2.50, ($250 total per option), Savannah could buy 2 of those options. If a debit spread also costs $2.50, the formula is the same and Savannah could buy 2 spreads. (Note: It doesn’t have to be all at once. Savannah can scale into positions through multiple purchases or sales of a contract or spread).

Sizing up a short option trade: For short strategies like credit spreads, the risk in each spread is the difference between the strikes minus the credit you receive.

For example, in the same $10,000 account, and using the same 5% rule, if you received $2 on a credit spread that is $5 between strikes, your risk is $3 ($300 total per spread). Since you can’t go over $500 risk, you can only trade one spread.

Well, a lot, Padawan. It’s worth mentioning that someone reading this (you might be one of them) might be thinking, “5%? No problem. I’ll just cut up my account into 20 trades at 5% each.” It doesn’t work like that.

As a general practice, you don’t necessarily want to use all of your capital just because it’s there. Consider starting with one at a time, at least while you’re learning and work your way up to a level that’s comfortable. The 5% rule isn’t about 5% dispersed across 20 trades, it’s 5% of what’s left in your account after you close this one. This means if the account goes down in value, your trade size also goes down. If your account increases, your trade size could go up. For many people, it can be good to continually reassess if 5% of a larger portfolio still fits your risk appetite.

Think of it this way: if Savannah spent 5% of $10,000 on 20 trades and all of them went to zero, she would be left with zero (assuming she's not trading on margin, she'd probably hit zero quicker).

This is where proper trade management can work - position sizing is just one way to control some of the risk that exists between your ears.

One last thing. Just because you’ve allocated a smaller loss per trade, doesn’t mean your work is done. There’s still strike selection, and more importantly, what strikes to consider avoiding. Just as risking all of your capital on one trade is a recipe for disaster, buying a bunch of cheap, out of the money calls for $0.10 each can be just as bad. One way to gauge your odds of potential risk is to look at the option’s delta.

Delta is one of those fancy “options greeks” you might have heard about somewhere. We’ll spend some time in other articles discussing greeks, but delta is worth highlighting here. Delta is like a swiss army knife for analysing risk. Let’s quickly break it down:

• Delta is the option’s price sensitivity to price changes in the underlying stock. If a call has a .10, or “10 delta” and the stock moves up $1.00, the option will only increase .10 cents in value. Not so great if you thought the option was going to move in lockstep with the stock.
• Another way traders use delta is as a back-of-the-napkin calculation for probability of the option expiring in the money at expiration. Our example call with a .10 delta has roughly a 10% chance of expiring in the money. Another way of thinking about this is the seller has about a 90% chance of keeping the credit you paid them. Think about that.
• And finally traders use delta to calculate the equivalent “shares” that the option is acting like. So, even though you may be buying a 10 delta option, a lot of small deltas add up to big deltas, and before you know it, you’re long thousands of deltas. That would be the equivalent of owning thousands of shares of stock (call the Risk Officer!).

Bottom line, deep, out of the money options are cheaper for a reason. They have a very low probability of success. In fact, many veteran traders call them “lottery tickets” because they are cheap and rarely pay off. Of course, when they do you’re sure to hear about it but, trust us, it’s the exception that proves the rule.

You can find delta on Robinhood by following the steps below:

1. Tap the Search icon at the bottom of your app
2. Search for a stock symbol
3. In the Stock Information Page, tap Trade, then Trade Options
4. Select the expiration at the top of the screen
5. Select the option from the chain you want to trade
6. Under “Limit Price,” select the bid/ask and you’ll see this:

The delta in this image is 0.3956, but that can be read as “39 deltas”—the equivalent of 39, almost 40 shares of stock. The option has roughly a 39% chance of expiring in the money by expiration.

At the money options hover right around 50 deltas, which means they’re expected to move $0.50 for every $1 move in the stock. So, if you’d like to emulate a similar profit/loss profile of 100 shares of stock, you could buy two at the money options. When the stock moves up $1, the two contracts that are at the money are expected to move up $1 as well. The reverse is true if the stock moves lower by $1.

The ‘why’ of delta is for another article, but the important point to understand is that it’s not linear. Delta changes, like the slope of a curve, and cheap out of the money options have an extremely low delta. There’s a sweet spot between the at the money and cheaper out of the money options that may offer a balance of cost and a higher probability of success.

Also, keep in mind, whenever you buy an option (no matter whether it is ITM, ATM, OTM), your theoretical probability of success is less than 50/50. It’s just how the math works out. And remember, the higher the delta, the greater the probability that the option could be in the money at expiration. For now, let that be your guide.

Remember, you are the Chief Risk Officer of your trading account. Risk management starts with you and the decisions you make before you place a trade. Manage your capital and manage your risk accordingly. The single most important tip we’ve learned from veteran traders over the years is to ask yourself, always, “what is my risk?”

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information purposes only and does not constitute financial advice. Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.

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Options are complex products, involve significant risk and are not suitable for all investors. You could lose more than your initial invested capital. You should only invest in financial products that match your knowledge and experience. Please review Characteristics and Risks of Standardized Options prior to engaging in options trading.