Risk: One Option Trader's Opinion

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When it comes to trades with unlimited risk, my stance is that the vast majority of traders should avoid them. The basic reasoning is that such positions require careful risk-management and we're concerned that newer traders -- not yet aware of the importance of developing good risk-management skills -- will be tempted to adopt these strategies before understanding just how much money can be lost. Skilled risk management is a necessary skill for any trader.

We all want to make money right now, but it is far more important to understand how to make money over the longer term, and that means it is necessary to learn how options work before placing your money at risk.

Each of us must decide which option strategies are suitable for our personal trading and which pass our tolerance for risk. To have enough information to make such a decision, strategies must be understood and practiced. That presents a significant problem for those who are in a hurry to get started. Newer traders may not want to be bothered with using a paper-trading account and decide to trade with real money — and real risk. For that reason, avoid any mention of strategies with too much risk.

We know that bullish investors always accept more risk than they realize. For example, when a trader is bullish, he/she seldom recognizes that buying stock is "dangerous." After all, prudent investors are encouraged to buy securities (and to hold onto them for the long term). No one believes that the price of his/her chosen stock may suddenly be 50% lower -- and stockholders do not think about the possibility of their accounts being cut in half. But it does happen, even if not very often.

Most investors feel secure when owning stock and many believe that options trading is for people who love great risk. This is simply not the case. Options are easily used to reduce risk. Here is one simple case in point:

  • Selling naked put options feels like an egregious thing to do -- to the person who does not understand how options work. 
  • People believe that buying stock is prudent but that selling put options is not.
  • Yet, owning 100 shares of stock involves the chance of losing more money than the seller of one naked put option. 

Buying stock is just as risky as some of the higher-risk option strategies. Option traders can easily hedge risk. For example, instead of selling naked puts, the trader can buy one put for each put sold. That may limit profits, but it cuts the maximum possible loss for the trade to a relatively small number (compared with selling naked puts).

Example

XYZ is $93.10 per share:

  • Sell 1 XYZ Nov 18 '16 90 put
  • Buy 1 XYZ Nov 18 '16 80 put

That combination is referred to as a put spread. In this example, you sell the XYZ Nov 80/90 put spread, with the options expiring after the market closes on Nov 18, 2016. The worst case scenario results in loss of $1,000 for the spread (reduced by the premium collected when initiating the position). This is a limited-risk trade.

The seller of the naked XYZ Nov 18 '16 90 put can lose up to $4,500 (less the premium collected) if the stock declines all the way to $45.00

The stockholder can lose $4,810 if the stock falls to $45.00. Obviously, the loss can be even greater when the stock price continues to decline. But the put spread seller can never lose more money -- no matter how low the stock price may be.

Bottom Line

Selling naked options involves the risk of incurring a significant loss, but so does buying stock.