Critical Options Trading Skills: Risk Control & Money Management

Experience and knowledge of all the trading strategies are irrelevant if a trader cannot control risk and manage money.

Most traders learn quickly that only a few mistakes or events out of their control can destroy a portfolio that was painstakingly built. Therefore, in addition to market analysis and different trading strategies, you must learn to manage your money and to control risk.

One of the most basic ways to control risk is to manage the amount of your investing capital that you risk with each transaction. The recommendation is that you never risk more than1% to 2% of your total investing capital on each trade. However, that amount is often not realistic for somebody who is starting out.

That rule is easy to follow if you already have a very large portfolio. For example, if you have more than $100,000 that you are ready to risk in options trading, you easily can stick to the 2% guideline. However, if you are just starting out or if you are willing to invest perhaps only $10,000, then a 2% limit will severely restrict your trading options.

There are few ways around this potential barrier. You can trade stock option mini-contracts on exchanges, or you can trade lower-priced options.

While stock option mini-contracts are fairly new, there is nothing new to learn and you will still use the same strategies that I have discussed. The only difference is that instead of having the typical leverage of 100 shares per option contract, mini-contracts control only 10 shares.

Ease into trading

While that may not sound very exciting, it is a perfect opportunity to start slowly and build your skills. With less risk, you can learn how to be a successful option spread trader by focusing on the process instead of dreading a potentially bad result. You can stay focused on perfecting your analytical skills and trade execution. Once the basics become second nature to you, winning trades and generating profit will became the norm.

While working at the basics might be boring, every great champion or person of notable success in any field became successful because he or she learned the basics and then built on that foundation.

I also recommend that you start trading with simulation accounts. That way, you can go through all of the emotions I have outlined here in the simulated trading environment and see how well they work for you. While losing simulated capital is not exactly like losing real capital, it will allow you to learn from making novice mistakes without going broke.

Trading with simulation accounts is a form of risk control because you can see how your trades can devour your investment capital when they go south. Fortunately, the trades I have focused on and explained in this series of articles are the types of trades that limit your downside.

After you have gone through the process of simulated trading, you will feel comfortable enough to execute real trades. A few successful trades will quickly build up your trading portfolio. As your trading assets grow, remember to reduce the share of your total investing capital on each trade until you reach the recommended 1% to 2% that I mentioned earlier in this article.

What Next?

I recommend that you engage initially in the types of trades that have a very limited downside, which will often be restricted only to what you invested in the trade. That way, you know your maximum loss exposure from the beginning.

The objective of option spread trading is to minimize risk by hedging your analysis of the market direction. If markets were predictable, we would not have to hedge or engage in spread trading. Since that is not the case, options spread trading is one of the least appreciated and best methods for you to create a part-time income from your trading capital.

The strategies for controlling risk are not complicated. You simply enter trades where you have limited your downside, do your homework to push the odds for profit steeply in your favor and make sure to identify the percentage of your portfolio that you are willing to risk, which should be below 5%.

While trading options spreads has countless variations and nuances, the overall process is rather simple. You have to analyze the markets, be aware of potential reversal patterns or exterior events such as political and news events that could bounce you out of your trade, use the process I have described to create a trading plan and follow your checklist to execute the trades.

Once you have set your risk tolerance bar, established your trading methodology and adapted to the option spread strategies, you are already in a low-risk trading environment. The real risk exposure occurs when you trade by picking only one side of the market or security. Options trading with the spread strategies that I recommend prevents that problem.

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