Risk management techniques are the MOST important aspect of an options trader’s trade plan. The setup and the trades are going to come a lot easier than knowing how much risk to take when to take risk-off, and when to scale into risk. Understanding your risk management will make you a better trader.
Throughout this post, we are going to talk about The Risk Management Techniques for an Options Trader in the following categories:
- Options Trading & Stop losses
- Options Day Trading & Risk Management
- Cutting Risk
- Taking on Risk
1. Options Trading & Stop losses
Options trading is a more complicated asset than you would think with stocks or futures. The movement in stocks and futures is very plain, black and white. You know how much you stand to lose or win based on the movement of the asset. If a stock goes up $10, then you will gain $10 per share that you hold. If a futures contract goes up by 1 point, if you are long, then you know the point denomination based on the asset traded. For example with the S&P 500, you know that 1 point is worth $50, gain or loss per contract.
Options are not that simple. They have many variables in their pricing and how they react to the underlying changes. So it’s not as easy to say, “under $XXX I’m going to just put my stop”. That is because the options position can go -50% or -60% by the time it gets to the level where the stop is. What if you only wanted to risk 20% of the premium?
When trading options you need to be aware of:
- The expiration date
- The strike chosen (ATM, OTM, ITM)
- The Greeks affecting price
The closer the options expiration and the farther OTM the options are, then you will be playing a riskier option in which case you should NOT base the stop on the structure support/resistance.
Here is an example of AMZN.
The yellow line is the support, on the second bounce at the green circle where we would enter the long. The red line would act as the stop loss.
Now, this seems like we’re good to go and see the potential gains on the horizon. However, let’s compare two different options contracts to see the potential in them.
The Oct29 3420C (2DTE)
Cost: $43/contract or $4,500
Peak of position: $50/contract or $5,000 (11% gain)
Pullback (second touch of yellow line): $4,300 (4.5% loss from original position)
Next run peak: $75/contract or $7,500 (74% gain)
The Nov05 3450C (9DTE)
Cost: $43/contract ot $4,500
Peak of position: $49/contract or $4,900 (14% gain)
Pullback (second touch of yellow line): $4,400 (2.3% loss from original contract)
Next run peak: $72 or $7,200/contract (67% gain)
The lesson here is that with the options, they don’t necessarily correspond to the underlying, in the first case, we did pullback and the contract turned into a loss, which in some cases it is, on a shorter-term expiry. Rather it came back to break even. Or even again, because we have gone in a little lower than the pullback on the underlying. While the further dated options contract came back to a loss as well but a lesser loss than the first. In some cases, we can see more volatile moves and go into a stop before ripping. This is common on Fridays or Thursdays.
Meaning when putting in a stop on an options position and when trailing it is important to choose the right options that are not too far OTM so the delta is respectably around 30%. Base the stop on the options contract if you are trading a shorter-term expiry. If you trade a stock that stays stagnant then doesn’t make the move the position will eventually lose value.
If you are trading a longer-term expiry you can trade based on the underlying. Based on the options position if you start with a 20-30% stop on the premium you are in a good position.
2. Options Day Trading & Risk Management Techniques
When it comes to risk management techniques for options traders, in day trades there are a few ways to look at things. Ask yourself, what are you willing to risk? What is an appropriate risk for my account size? Because when you day trade options realistically you are going to trade short-term options, a week or 2 weeks of the time max. Trading with a stop based on the underlying isn’t necessarily recommended because it doesn’t take into account the other variables.
How much risk to take?
Typically day trades can be divided into 3 different categories; day trades, scalps, and lotto play.
The day trade is a long trade that may last all day or tens of minutes to hours. Typically a trader is looking for 30-40% ROI on average or minimum. Meaning that a stop of 20-30% would do the job. Some traders are willing to use a 50% stop and cut the position sooner if the position starts to fail.
The scalp is a trade that lasts anywhere from seconds to minutes. They’re looking for a 15-20% move quickly, so taking about 15% risk is going to be the average.
The lotto play is a lottery ticket, you have an idea, calculated, but the risk is 100% of the premium, usually taken on a Friday or late in the week. Risk to reward is drastically different from the other strategies.
The percentages are based on the risk of the premium.
Cutting Risk
Knowing when to cut the risk is a vital part of day trading options risk management. Which can be done in two ways: taking the position off soon, for either a smaller loss or a smaller win (scratch). Or trailing the profit so you have a risk-free position.
Cutting risk based on a scratch comes from watching the chart and your technical analysis. Are you anticipating a reversal in your trend based on the options order flow or something you see on the chart? If so the position can really eat away at your profits.
Here is an example of MSFT on a day trade. Given in our live Options Room. Current Day: Thursday Oct27 2021, MSFT 330C Oct29 trade given at 0.70/contract.
Stop identified at 25% from $70/contract is $53/contract where I would put my stop loss.
On the 5-min chart, we formed a base on MSFT at the 20 EMA and we saw the volume perking up. We would have wanted to get the trade a little earlier. However, we got it on the yellow line break where price confirms the move.
At this point, you can see the options pricing in the image below. Where we have the blue arrow that indicates we’re getting long. With the stop under the structure lows. The first take profit is at 30% profit. Then we trail to break even! That is cutting our risk.
Now we have 30% of the position out at 30% and the rest at break even. Then we saw a blimp in price, which is not even replicated in the underlying so we cut another 30% at +5%. The rest of the position is left at break even. We got a 95% move in this trade. Where we trimmed 20% on the trade, left with 20%. Which got hit on the trailer. The underlying dropped about 0.4% from the green start image. While the options lost about 40% of value, coming back to about the +30% gainer market. Based on our risk management we wouldn’t have survived this. There is nothing worse than being really green and going red in a position. Price then moved to 1.50/contract which would’ve been over 100%.
Our risk management principles involve taking risks off at 30%. Take ⅓ of the position at a 30% profit. Then put the stop on the rest at breakeven +1-3% so you can secure something. Then look for a move into 45-50% gain, take ⅓ off. Put the stop at 10% then let the rest run. Each 10% rally in the gain, increases the stop by 10%.
Taking Risk
The easiest way to define taking risk as a day trade is taking on a position. However, there is such a thing as ADDING risk. Which can be done in two ways: averaging down, or averaging up.
The better way to take risk in a position is averaging up, meaning if you already have a position and you are up on the position. You can add more to the position to take advantage of your move, ONLY risking what you have already gained.
The other way is for traders to add into losers, but that is a dangerous game. Yes, you will have a lower average fill but the position is going against you. Adding size to it will burn a deeper hole in your pocket. Now you have massive size and it’s going against you. Lose lose!
On the other hand, if you have a position which is up 30%. And you add to it, risking even 20% you’re still going to have a winning position.
Let’s assume you buy calls for $1.00 a contract. You buy 10 of them. The position goes up 30% and you still have full size. The premium goes from $1,000 total to $1,300. You decide to add 5 more, so you don’t oversize. For $1.30 a contract. Your average fill is now $1,000+$650 = $1,650/15 = $1.10 per contract.
Now that your average fill is $1.10 per contract. And the current price is $1.30 you’re still up 18% on the position.
Even if you risk 20% of the position you are at a -2% loss. If you were up MORE on the position and sized less you can still work it out so you take home some kind of profit.
You can consider these Risk management techniques for swing traders as well. In that, you can cut risk and add risk the same way. The idea here is that you want to make sure that you are aware that if you hold positions overnight you can have larger swings in the price action that could affect your net profit and even your trailers.
Conclusion
Overall Risk Management techniques for Options Day Traders can be defined when we understand our risk tolerance and accept the risk that we take. It’s not enough to get into a position and just let it go. But instead, we want to manage our trailers, our positions, and how we get out of the trade, making sure that we can profit from the options that we have.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
