Options Trading and Risk

Is options trading risky?

Is options trading risky? This is one of the most popular questions that options trading beginners ask. In fact, my clients ask me this same question all the time. I would then ask them “What do you mean by risky?”. The usual answer would be “Can I lose a lot of money in options trading?”.

 

At least this brings us somewhere. Asking if options trading is risky without a clear idea what risk is in the first place gets nobody anywhere.

 

Risk is defined in many different ways to different people and for most people, risk is simply an expression of their fear of losing money. Whenever I am asked by an options trading beginner if options is risky, I know what they are really telling me is that they don’t want to lose money. How can we address this “risk” then?

 

Even though there are many ways to define risk in the financial sense, I think my 2 parts explanation caters best to the needs of the common retail investor. In my 2 parts explanation, risk in options trading for common retail investors are made up of; 1, Probability of Loss. 2, Consequence of Loss.

 

It’s like crossing a street. The probability of death is small but the consequence of death is catastrophic. However, because the probability is so small, we continue to do it every day.

 

In stock trading, you cannot really control the probability of loss because you win only if the stock goes up. That is why stock traders reduce the consequence of loss by having sensible stop loss in place.

 

See how the probability of risk and the consequence of risk interact with each other now?

 

The good news about Options Trading is that you get to control both the probability of risk and the consequence of risk! If you can control both elements of risk, won’t options trading actually be less risky than stock trading?

 

Options trading reduces the probability of risk through options strategies that profit from more than one direction. In fact, there are options strategies that profit when the stock goes up, down and sideways all at once! When you can profit in so many different directions all at once, won’t your probability of risk be dramatically reduced? An example of such an options strategy is the Call Ratio Spread which makes a profit if the stock goes up to a certain limit, stay stagnant or go down endlessly.

 

Options trading reduces the consequence of risk through leverage. Leverage cuts both ways. If you abuse leverage and buy options like you buy stocks, then you are in big trouble. However, if you use only money you can afford to lose in each options trade and make use of its leverage to produce the same returns that you would if you have bought the stocks instead, won’t the consequence of risk always be within your acceptable limit? An example of this is the Fiduciary Call options trading strategy.

 

Since the probability of risk and the consequence of risk can be dramatically lower in options trading than in stock trading, is options trading still “risky”?

 

Risk can be defined in many ways and options trading is inherently risky due to its nature as a leveraged derivative instrument. However, with sensible control of the probability and consequence of risk, your options trading experience may be a lot less “risky” than you think. Options trading becomes “risky” when you lose control over these 2 critical elements.