Trading options is exciting, complex, and potentially profitable. But there’s also no denying that it comes with inherent risks that investing in stocks doesn’t. There are too many things that can go wrong for novice traders to try their hands at options trading, which is why many trading experts do not recommend it. If you’re a beginner or experienced stock market trader, there are ways to manage the risk associated with options trading. In this post, we’ll discuss how to control the most common risk in options trading.
Risk 1: Wrong View
Traders will lose money if the underlying moves in the opposite direction of their expectations. If the underlying price declines, a call buyer makes a loss, and if it rises, a call seller makes a loss. When the market rises, a put buyer loses, and when it falls, a put seller loses.
How to control:
Before forming your opinion about the underlying, do your research on how to trade in futures and options. To execute an option trade, you can search the Internet or meet with experienced traders or brokers like Kotak Securities. You can also avoid this problem by executing combination strategies in options instead of just buying or selling calls and puts.
Risk 2: Decay in Time value
A decay in time value causes options to lose value over time. Consequently, the longer the option buyer holds onto the position, the more the time value of the option decreases, resulting in losses.
How to control:
Time decay results in a loss for the option buyers and a profit for the option sellers. When you buy and sell options simultaneously, you lose time value in the bought option position but gain time value in the short option position, so the loss is offset. This will minimise your losses.
Risk 3: Changes in Volatility
When the volatility of the underlying increases, the value of options increases, and when the volatility decreases, it decreases. Consequently, if volatility decreases after you buy an option, the option premium will decrease, and you will lose money.
How to control:
Understanding the Options Greek called Vega will help you manage the risk of changing volatility. Using it, we can determine how the option premium changes when volatility changes. To understand each option’s risk-return profile, you must learn about Option Greeks. By doing this, you will be able to determine whether or not to enter a trade.
Risk 4: Margin Shortage
This is another common reason for option traders to lose money. Your broker will make a margin call if you face a margin shortage or a mark-to-market loss after selling an option. In the event that you don’t pay, the position will be squared off, and the loss will be booked.
How to control:
You must calculate the margin required before executing a trade and make sure that you have the necessary funds. If your option position loses, you will have to pay mark to market margins.
If there is a margin call, you should keep some extra money available beyond what you’ve calculated to ensure that you can manage your position smoothly.
Risk 5: Heavy Movements in the Market
You will lose a lot of money if you sell call or put options expecting the markets to remain rangebound.
How to control:
There is a greater risk of loss for option sellers when the market moves rapidly. To avoid such losses, always hedge your options position if you have sold them.
Risk 6: Gap Up / Gap Down Openings
Options traders lose heavily if the market opens sharply higher or lower than the previous day’s close.
How to control:
The problem here is similar to that of heavy movement. To avoid gap up and gap down movements in the underlying, hedge your position properly.
Risk 7: Liquidity Risk
A liquidity risk occurs when there are not enough buyers or sellers in a particular option, or the bid-ask spread is quite wide. In that case, you will have difficulty entering and exiting your position and incur a large loss.
How to control:
In order to avoid liquidity risk, you should identify options with a lot of open interest. By doing this, you will have many traders who will be ready to square off their open positions by becoming your counterparty when you try to square off your open position. As a result, the trade will take place easily and at the right price.
Conclusion
Trading options involves creating a plan, sticking to it, and using clever strategies to mitigate risk and maximize profits. You can effectively trade options using the best mobile trading app. Furthermore, it is possible to get lucky on the stock market, especially with options trading. However, only those who use the right risk management strategies will be able to maintain their profits. Put these tips to use in your options trading strategy to minimise risk.
