Turning Risk Into Profit With The Right Options Strategy
It was the perfect day to learn how to surf. Not a cloud in the sky. The waves came along almost as though they were on demand. Miss one? No worries – take the next one and get your balance. Little did anyone know that lurking just below the surface, a great white shark was sizing up his afternoon snack.
Every year there are 70 shark attacks reported worldwide. In the Options market, an account-disfiguring shark attack equivalent happens every minute across every options chain. Why? Most traders have no idea of the dangers that lurk in the water just below their trade.
Fortunately, there is a way to quickly plot and compare the risk you’re taking with every trade. Better to know beforehand if you’re putting blood in the water, or if you’ve reduced your risk.
Why most options trades sit directly in shark-infested waters
Statistically, most shark attacks take place on males – half of them being surfers who are treading into their territory – a stat that’s been tracked since 1580. If you happen to be swimming or snorkeling at New Smyrna Beach in Florida, you’re in the shark attack capital of the world according to ISAF. Anyone who’s swam there has likely been within ten feet of a shark.
If you’ve traded options, or even looked at an options chain – you’ve been within a mouse click from an attack on your account. Sadly, many retail traders swim into options completely unaware of the risks presented with each selection their broker offers them.
It’s not for lack of interest or caution. Most would argue that they’re very careful when planning their options trade. In reality, most courses, videos and self-help books only talk about the upside – guiding traders to the attractive, but blood-filled waters of long call options.
Fortunately, there’s a very quick way to plot your relative risk when selecting your options strategy.
Organizing your strategies to manage risk
A simple concept applies to sharks… ‘if you don’t bother them, they won’t bother you.’ The most common type of shark attack is one that is provoked, when sharks become aggressive because they’ve been disturbed or approached. Divers who veer into their hangouts, try to grab them and swim with them are asking for trouble.
The same applies to options trades that aren’t carefully examined. There’s a simple question you can ask when venturing into the shark-infested waters: Exactly how much risk would you like to assume? Would you like unlimited, unmanageable risk? Or would you like to limit your risk and decrease your volatility?
Perhaps another question: Are you willing to clear your account in exchange for one home-run trade? If the answer is ‘no’, then you may be interested in plotting your options trades based on risk and reward. Simply put: The more reliant the success of your trade is on the direction of a stock or market, the less likely it is to deliver a profit – unless the stars align.
Additionally, the more exposed it is to a single event causing serious problems for your position, the greater the risk. Viewed through this lens, you can quickly organize your strategies.
Non-directional index trades present the lowest event risk and come with comparatively lower reward. These are the trades that generate consistent income – like iron condors and credit spreads. Directional stock trades, like long call options, present a ton of upsides but are exposed to just about every event risk you can imagine. This list of these risks is never-ending, ranging from missed earnings reports all the way to corrupt CEOs who get hauled away in cuffs.
Guess where most beginner options traders start? You guessed it, the upper right. All while they could be generating income and reducing the risk their account is exposed to.
Allocating capital to generate consistent profit
Some believe that sharks may acquire a taste for humans after repeatedly consuming human flesh. Not likely, according to most scientists. In many instances, sharks mistake humans for their regular prey because of actions or appearance. In many instances, it only takes one bite and the shark realizes that it’s got the wrong prey. Unfortunately, that’s all it takes.
The same is true with a bad options trade. You can manage this risk by allocating your capital so that it’s proportionate to the risk you’re assuming with any trade you contemplate. Income-generating trades that aren’t completely based on the direction of an index often produce more consistent results. Deploying the base of your capital to these strategies can help deliver the month-after-month income you’re looking for.
For as unappealing and unglamourous as it may seem, applying the smallest portion of your capital to the home-run trades will preserve your resources. The returns when these trades perform will still be attractive, and your risk when they don’t will help you avoid clearing out your account.
Amazingly enough, most retail options traders do the exact opposite – essentially winning and losing the same capital base without making any progress.
Avoiding shark attacks on your account while profiting
A large shark is an ‘apex’ predator in their environment. They have little fear of anything that crosses their path. It’s often curiosity that leads to trouble. Their preferred method of exploring something? Bite it. Bad news if you’re a human.
Don’t take unnecessary risk when venturing into the open waters of the options market. Know exactly what type of event risk you face and whether your trade can handle it. Don’t be surprised when a stock faces an unforeseen attack that sends your trade in one direction or another. Avoid allocating your capital into trades that have the ability to wipe you out.
Take an integrated approach to your options trading, using the quadrant system to organize your risk and your strategies. Incorporate indexes, and rely less (not more!) on market direction to generate returns.
Surf the open waters with confidence – not fear – with options strategies that reduce your risk wherever possible.