How to Minimize Option Trading Risk

One of the main advantages of options is the ability to minimize option trading risk. When I buy an option, I automatically limit my risk to the amount of money I paid for those options.

However, when I sell an option, I expose myself to virtually unlimited risk. Some traders consider selling options too risky. However, selling options also happens to be one of the best ways to make money with options.

Identifying risk with options

Options spread trading requires selling calls and puts frequently. The key to controlling the risk with selling calls and puts is proper trade setup, understanding the technicals of the underlying security and understanding the risks of the trade from all angles. The strategy is to minimize the risk of each trade by protecting ourselves with the option spread strategies discussed in this and related articles.

Selling options can be set up properly in the form of calls or puts to manage risk in pursuit of profitable trades. The aspect of option trading dealing with risks of options concerns the two terms known as exercising and assignment.

Exercising an option means that the person holding the option decides to use it. If I sell a call and the buyer decides to exercise the call, I must deliver the stock or the underlying security to the buyer as the option dictates.

Assignment is when the seller of the option is called to fulfill the obligation defined by the option contract. The person or institution that wrote the option is said to be assigned to deliver on the terms of the options contract. According to the options clearinghouse data, about 17% to 20% of options have been exercised historically.

Surprisingly, I have never had an option exercised, and I have never had an option assigned to me. Part of the reason for my good luck at avoiding exercising and assignment is that I tend to trade options in the commodities market rather than in the stock market. Because of physical inventory implications in the commodities market, the other side of those trades has no interest in taking delivery on large futures contracts. If you are trading in the stock market, you must take assignment and exercise into consideration in your trading setups.

Option spread trading

You could focus your option trading strategy on either just going long or short or just buying puts or calls. However, option spread trading offers some of the best profit opportunities while simultaneously minimizing losses.

I often have wondered why all options traders do not use spread trading strategies. I believe the reason more options traders do not take advantage of options spread trading strategies is that they simply do not understand how to set them up and benefit from them. As soon as they understand the concepts and put some time into developing options spread strategies for themselves, they realize what a great opportunity options spread strategies are.

Options spread trading is simply using the purchase and sale of options of the same class on the same underlying security but choosing different expiration dates or a different strike price.

When I buy a call or a put, I am betting on whether the underlying security will go up or down to generate profit. However, when I use an option spread trade, I am concerned mainly about the relationships between the two options — not about the absolute price of the underlying securities. This will become more obvious as I dive into some of the options spread trading details.

Getting credit

One of the great things about options spread trading is that my net cost of trading is reduced, even though I am making double the number of trades compared to buying or selling single options. Instead of paying the premium cost of the option price, I am now receiving the premium cost because I’m selling the option that reduces my net cost of entering options trades. That is just another major benefit of options spread trading. You can get paid when you enter the trade, which is called getting credit.

Getting a credit and getting paid when entering a trade means that we also have to enter into a risk relationship with the person who has purchased the option we sold. Once I explain in more detail how options spread trading works, I am confident that the details of this credit concept will become clear. For now, it is enough to understand that unlike buying individual calls or individual puts, in options spread trading we are getting a discount — a net credit — for the trade because we are on the other end selling a call or a put.

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Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.