Options trading risk free

Understanding Options Risk.

How to Trade Options.

By Beth Gaston Moon, InvestorPlace Contributor.

By understanding risk, you can become a better and more profitable trader.

Many investors get excited about options trading because they love the leverage that is possible when an investment goes well. While stock investors might make 10% or 20% returns on a stock, aggressive options investors could potentially make a 1,000% return in the same amount of time.

Those types of returns are achievable because of the leverage offered by options trading. The savvy options trader recognizes that he or she can control an equal number of shares as the traditional stock investor for a fraction of the cost.

Less-savvy traders might not realize the leverage they already wield and decide to spend as much money as they would have spent to establish a long stock position and invest it all into a huge options position. For example, instead of spending $3,000 to buy 100 shares of MSFT at $30, one might spend $3,000 in MSFT options. With options trading, no one needs to spend like this. One tremendous benefit of trading options is limiting one’s risk, not multiplying it, as this would do.

A good rule of thumb to use is not to invest more than 3% to 5% of your portfolio into any one trade. For example, if you had a trading portfolio of $25,000, you would only use $750 to $1,250 per trade.

Trading options is NOT about merely trading risk for equal reward. Instead, your goal is to gain a professional trader’s edge. You should seek to reduce risk through careful selection of investment opportunities and, at the same time, capture bigger returns. There will be losses, for sure. But ultimately every trader’s goal is to shift the ratio of winners-to-losers to favor strong and profitable portfolio returns.

Any investing carries a certain amount of risk. Options investing assumes greater risk, so you should make sure you understand the pros and cons of the strategies you are considering before you start actively trading.

Without going into a discussion of the Greeks (e. g., delta, theta, gamma), the risks described below are among the most common in options investing. When you open an options trading account, you’ll receive a complete guide of options trading risks from your broker.

Time Isn’t Necessarily On Your Side.

All options expire — most at zero value. Unlike stock investing, time is not your friend when you are holding long options. The closer an option gets to expiration, the faster the premium in the option deteriorates.

This deterioration is very rapid and accelerates in the final days before expiration. As an options investor, you should invest only a dollar amount that you’re comfortable losing, because you could lose it all.

There are three things you can do to put time on your side:

• Buy options at the money (or near the money).

• Trade options with expiration dates that comfortably encompass the investment opportunity.

• Buy options at a point where you believe volatility is underpriced, and sell options when you believe volatility is overpriced.

Prices Can Move Very Quickly.

Because options are highly leveraged investments, prices can move very quickly. Options prices, unlike stocks, can move by hefty amounts in minutes or seconds rather than hours or days.

Depending on factors such as time until expiration and the relationship of the stock price to the option’s strike price, small movements in a stock can translate into big movements in the underlying options. So how can an options investor make money unless he or she watches the options pricing in real-time all day long?

Answer: You should invest in opportunities where you believe the profit potential is so robust that pricing by the second will not be the key to making money. In other words, go after large profit opportunities so there will be plenty of reward even if you aren’t precise in your selling.

Additionally, do all you can to structure the options purchase using the right strike prices and expiration months so that much of this risk is reduced. Depending on your personal risk tolerance, you might also consider closing your option trades with enough time before expiration that time value isn’t deteriorating so dramatically.

Losses Can Be Substantial On Naked Short Positions.

Much like shorting stocks, shorting options naked (i. e., selling options without hedging the position via other options or a stock holding) could lead to substantial and even unlimited losses.

Naked short in options means you’re selling a put or a call by itself, without securing it with cash or another stock or option position. You might be wondering how else you could sell a put or a call. Many investors prefer to sell puts or a calls in combination with stock or with other options. This removes the potentially unlimited risk of the “naked” put or call that is being sold. The covered-call section below is an example of this kind of strategy.

Although many will use the word “short” to describe selling options to open, it’s not exactly the same structure as shorting a stock. When you short a stock, you’re selling borrowed stock. At some point in the future, you have to return the stock to its owner (typically by way of your broker). With options, you don’t borrow any security. You simply take on the obligations that are associated with selling options in exchange for the premium payment.

What makes shorting options naked (which is also known as selling volatility) tantalizing is the possibility of having a steady source of gains. Much of the professional investing world has booked gains from selling options, as the underlying stocks have been less volatile than what their options premium was implying.

For example, if we sold near-the-money 12-strike May puts in Ford Motor (NYSE:F) and collected 58 cents, we would keep this premium if the stock remained above $12 per share through May expiration. The short put achieves its maximum potential profit if Ford moves higher, stays put, or even falls slightly to the 12 strike. Much of the time, stocks don’t move as much as investors would expect.

There’s an important difference between selling to open a call naked versus a naked put. When you sell a naked call, your theoretical risk is infinite. You’re on the hook for the difference between the strike price and the amount the stock moves above this price. Because there isn’t a limit to how high a stock can trade, your potential loss is infinite.

However, when you sell to open a put naked, your maximum loss is the difference between the strike price and zero. Risk for a sold naked put is the same downside risk as owning the underlying stock at the strike price. In other words, stocks cannot trade below $0, so your potential loss is capped, though for some high-priced stocks, a fall down to $0 might seem virtually unlimited!

Selling puts naked can be an excellent way to have long exposure to a stock at a better price. You may be eyeing a stock, but the stock always seems too expensive. Rather than chasing the stock price, you can sell a put, collect the premium for doing so, and become long the stock at your strike price if the shares move to that strike price.

For example, you may have wanted to own Microsoft (MSFT) during one of its market rallies, but paying more than $30 per share seemed excessive. Rather than pay that much, you could sell the MSFT October 30 puts for $1.50. You collect this premium today, and your effective cost for MSFT if you are obliged to buy the stock (or “put to” the stock) is $28.50 ($30 strike price minus the $1.50 collected).

If you are interested in the put-selling strategy, it is recommended that you start small. Get a feel on a personal level for what types of outcomes are possible. Make sure you’re investing only the amount of money you’re willing to lose entirely.

When you enter your options trades with your eyes wide open and realistic expectations, you’ll be better at managing your trades and, in turn, your risks. Again, only put 3% to 5% of your trading funds into each trade. That way, if the trade goes against you, you’re not going to lose your shirt and be unable to rebound from the loss.

Another great way to become familiar with options trading before you use real money is to paper trade, which means you’re tracking options trades “on paper” from start to finish without investing any money. This will help you gain some skills and confidence without risking your money until you have a better understanding of how options trading works. One easy way to “paper trade” is through a virtual account at your online broker.

Article printed from InvestorPlace Media, investorplace/2012/04/understanding-options-risk/.

More On InvestorPlace:

Reducing Risk With Options.

Many people mistakenly believe that options are always riskier investments than stocks. This stems from the fact that most investors do not fully understand the concept of leverage. However, if used properly, options can have less risk than an equivalent position in a stock. Read on to learn how to calculate the potential risk of stock and options positions and discover how options - and the power of leverage - can work in your favor.

[ Looking for a shortcut to calculating risk when trading options? Investopedia Academy's Options for Beginners course provides you with an advanced Options Outcome Calculator that gives you the data you need to decide on the right time to buy and sell puts and calls. ]

Leverage has two basic definitions applicable to option trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into trouble. A dollar amount invested in a stock and the same dollar amount invested in an option do not equate to the same risk.

The second definition characterizes leverage as maintaining the same sized position, but spending less money doing so. This is the definition of leverage that a consistently successful trader incorporates into his or her frame of reference.

Interpreting the Numbers.

Consider the following example. If you're going to invest $10,000 in a $50 stock, you might be tempted to think you would be better off investing that $10,000 in $10 options instead. After all, investing $10,000 in a $10 option would allow you to buy 10 contracts (one contract is worth one hundred shares of stock) and control 1,000 shares. Meanwhile, $10,000 in a $50 stock would only get you 200 shares.

In the example above, the option trade has much more risk compared to the stock trade. With the stock trade, your entire investment can be lost, but only with an improbable movement in the stock. In order to lose your entire investment, the $50 stock would have to trade down to $0.

In the option trade, however, you stand to lose your entire investment if the stock simply trades down to the long option's strike price. For example, if the option strike price is $40 (an in-the-money option), the stock will only need to trade below $40 by expiration for your entire investment to be lost. That represents only a 20% downward move.

Clearly, there is a large risk disparity between owning the same dollar amount of stocks to options. This risk disparity exists because the proper definition of leverage was applied incorrectly to the situation. To correct this problem, let's go over two alternative ways to balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation.

The first method you can use to balance risk disparity is the standard, tried and true way. Let's go back to our stock trade to examine how this works:

If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts. By purchasing the options, you can spend less money but still control the same number of shares. The number of options is determined by the number of shares that could have been bought with your investment capital.

For example, let's suppose that you decide to buy 1,000 shares of XYZ at $41.75 per share for a cost of $41,750. However, instead of purchasing the stock at $41.75, you could also buy 10 call option contracts whose strike price is $30 (in-the-money) for $1,630 per contract. The option purchase will provide a total capital outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60% of what you could have invested in XYZ stock.

This $25,450 savings can be used in several ways. First, it can be used to take advantage of other opportunities, providing you with greater diversification. Another interesting concept is that this extra savings can simply sit in your trading account and earn money market rates. The collection of the interest from the savings can create what is known as a synthetic dividend. Suppose during the course of the life of the option, the $25,450 savings will gain 3% interest annually in a money market account. That represents $763 in interest for the year, equivalent to about $63 a month or about $190 per quarter.

You are now, in a sense, collecting a dividend on a stock that does not pay one while still seeing a very similar performance from your option position in relation to the stock's movement. Best of all, this can all be accomplished using less than one-third of the funds you would have used had you purchased the stock.

Alternative Risk Calculation.

The other alternative for balancing cost and size disparity is based on risk.

As you've learned, buying $10,000 in stock is not the same as buying $10,000 in options in terms of overall risk. In fact, the money invested in the options was at a much greater risk due to the greatly increased potential of loss. In order to level the playing field, therefore, you must equalize the risk and determine how to have a risk-equivalent option position in relation to the stock position.

Let's start with your stock position: buying 1,000 shares of a $41.75 stock for a total investment of $41,750. Being the risk-conscious investor that you are, let's suppose you also enter a stop-loss order, a prudent strategy that is advised by most market experts.

You set your stop order at a price that will limit your loss to 20% of your investment, which is $8,350 of your total investment. Assuming this is the amount that you are willing to lose on the position, this should also be the amount you are willing to spend on an option position. In other words, you should only spend $8,350 buying options. That way, you only have the same dollar amount at risk in the option position as you were willing to lose in your stock position. This strategy equalizes the risk between the two potential investments.

If you own stock, stop orders will not protect you from gap openings. The difference with the option position is that once the stock opens below the strike that you own, you will have already lost all that you could lose of your investment, which is the total amount of money you spent purchasing the calls. However, if you own the stock, you can suffer much greater losses. In this case, if a large decline occurs, the option position becomes less risky than the stock position.

For example, if you purchase a pharmaceutical stock for $60 and it gap-opens down at $20 when the company's drug, which is in Phase III clinical trials, kills four test patients, your stop order will be executed at $20. This will lock in your loss at a hefty $40. Clearly, your stop order doesn't afford much protection in this case.

However, let's say that instead of purchasing the stock, you buy the call options for $11.50 each share. Now your risk scenario changes dramatically - when you buy an option, you are only risking the amount of money that you paid for the option. Therefore, if the stock opens at $20, all of your friends who bought the stock will be out $40, while you will only have lost $11.50. When used in this way, options become less risky than stocks.

Determining the appropriate amount of money you should invest in an option will allow you to use the power of leverage. The key is keeping a balance in the total risk of the option position over a corresponding stock position, and identifying which one holds the higher risk in each situation.

The Top 10 Risks of Trading Options.

Risk is a core element of trading in the Stock Market. When trading any security at any level, there is no way to avoid risk, but only the ability to manage and minimize that risk. Any professional trader would agree that risk management is a critical component of building a successful portfolio over the long-term . And within that, the art of trading options carries risks, just the same. It is critical to your trading success that you recognize and understand the most common risks that come along with trading options.

The first risk, and one of the most important, is the risk of losing your entire investment in a relatively short period of time. Options carry with them an expiration , and if you ride that option contract until the expiration date, losing your entire investment will be the byproduct. Along with that, is the fact that you can lose your entire investment BEFORE the expiration date, as the option goes further out-of-the-money (OTM). Without tending to your option contract, you are bound to wave your investment goodbye.

Option contracts have what are called exercise provisions. Just like with any contractual agreement, these are the rules, regulations, and limitations tied to the contract that the buyer must adhere to. With these provisions, come obstacles that create risk that is out of your hands and out of your control. T he only control the buyer has is to either not purchase that particular option contract, or manage that position based on the provisions he or she is trading . Also critical, is the fact that regulatory agencies may impose exercise restrictions which may stop you from seizing certain opportunities and realizing value.

Now when it comes to selling options, there are also particular risks that come along with this side of the business. In perfect design, the relationship between an option contract buyer and seller should be always be mutually beneficial. But the inherent risk is the simple fact that options sold may be exercised at anytime before expiration, at the buyer’s discretion .

When it comes to selling different types of calls, there are risks and parameters that come along with each entry. Concerning selling covered calls, the risk lies in the fact that you forgo the right to profit when option’s underlying stock rises above the strike price of the call options sold . You then continue to run a risk when the underlying stock declines past your covered call income.

There will always be risk when dealing with selling naked calls and puts. The critical risk to note is that sellers of a naked call risk unlimited losses if the underlying stock rises and, inversely, that sellers of a naked put risk significant losses if the underlying stock drops. Sellers of naked positions also run “margin call” risks if the position yields significant losses. Such may include, but are not limited to, “subject to liquidation” by the broker. This is not fun and should be avoided at all costs!

A stipulation that may run a risk without the right strategy, is that as a seller of stock options, you are obligated under the terms of the contract to deliver the option they sold whether or not a trading market is available or whether or not they are able to perform a closing transaction. In that same context, is the fact that the value of an option contract (call or put) may surge or plummet unexpectedly when the underlying stock or security moves drastically, leading to automatic exercises and losses.

You cannot run from risk. With trading any security in the Stock Market, and of course trading stock options, there will always be risk brought on by the nature of the security and the risks brought on by your trading decisions. Of course, you can implement the various proven strategies to guide your trading, there is also risk in adhering to the complexities of these strategies. There is no way to avoid risk in the Stock Market, there is only to manage and minimize risk.

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How To Get Risk Free Trades.

Risk free trading is the holy grail of day trading. While stock traders have been scheming creative ways to mitigate risk for over a century, they are never really able to eliminate all risk.

Even a high tech hedge fund running a high frequency trading algorithm is open to the risk of flash crashes or technology errors disrupting their trading. See the story behind the line of code that almost took down the largest US market maker, Knight Capital.

Binary Options Brokers That Offer Risk Free Trades.

For small to medium retail traders, your typical day trader, there finally is actually a risk free trade proposition. Tradorax is letting anyone who funds a binary options account have 2 risk free trades! That means even if you lose, your account will not be negatively impacted. It will be as if the trade never happened.

For an example of how much this can help you, think of a trader who places 4 trades. Now, some traders are better than others, but overall, about 50% of trades will be winners, and 50% will be losers. This means that from 4 trades, a trader who meets the averages can expect to be correct on 2 of them, and lose on the other 2.

This would result in an overall loss for the trader in his account if all trades are the same size.

Now imagine that the same trader has 2 winning trades, and 2 risk free trades that do not lose any money. If each trade returns 80%, The trader will return an astounding 160% on his 2 winning trades, if all trades use the same amount of capital.

He will not lose any money on the incorrect trades, and from 4 trades the trader has made a higher return in a short period of time than most pros make in a year! Even if a trader only makes 4 trades and withdraws all his money, he can net a nice profit.

Risk free trading sounds too good to be true, but 24option and BancDeBinary have made it a reality. Why would they basically give money away? The first reason is they know only about 50% of the trades will be losers. A trader has to choose the trade as his risk free trade before he initiates the order.

So even if the trader has a winning trade, he will still use one of his risk free trades. This still is a huge advantage to traders though. Some traders will end up losing on both of their risk free trades, and the savings will be immense.

The second reason they do this is because it is a great promotion. They know that traders will not usually stop after the two free trades, and that they have an opportunity to generate profits in the long run. The onus is on the traders to be smart and take their profits while they are still on the table.

So while risk free trading has until now been a bit of a myth, Tradorax has created a great new opportunity for new accounts with their brokerage. If you want to take advantage of this offer while they are running the promotion, you must open and fund your account with their low minimum deposit. Remember it always pays to be smart.

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