As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running posts diving into the finer details of options education. This week, we are looking at how money management can be applied to options trading.
It’s no secret that options trading involves a fair amount of risk, but in recognizing it, it becomes easier to manage. One way traders limit risk is by diversifying their trades. In other words, it’s not a good idea to put all of your available capital into a single trade, or “all your eggs into one basket,” so to speak. In general, avoiding vulnerability to a downturn in one area by combining a mix of stocks, bullish and bearish options, bonds, and cash will help form that protection.
With that comes a certain amount of discipline and patience, as it can be easy to want to follow the herd, or enter and exit positions using rash decision-making. However, it is better to stick to your own carefully considered and well-researched plan, which should have an exit strategy at the start. Overall, maintaining composure in regard to each trade is an important aspect of risk management.
When creating your strategy, the size of the trade plays a crucial part, as it is the money-making aspect after all. After deciding how much you’re willing to pay for the option, use limit orders instead of market orders to control your entry price. Overall, one strategy is to see how many trades you can have at the same time, give yourself a hefty cash cushion, and spread your remaining capital evenly throughout the positions.
Lastly — and one of the more advantageous uses of options trading — use partial closeouts to lock in profits or manage losses, particularly after a sharp move happens early on. Throughout it all, there will likely be losses, but they can be learning experiences that help you hone in on what approach works best for you. In an ever-evolving market, it’s important to stay an active learner.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.