Options Trading Risk Management: 3 Secrets To Prevent Portfolio Panic

In options trading, risk management is paramount to your success. Here are three basic rules you must follow in order to manage risk while trading options, or at the very least avoid blowing up your account.

Market Rebellion

This article was last updated on 11/02/2022.

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Here’s something you won’t see the options gurus on TikTok tell you: options trading involves risk. That’s why your trading needs risk management.

If you have an options trading account, you’ve seen this statement.

All investments involve risk, and the past performance of an underlying stock, security, digital asset, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns.

But you’ve probably ignored it. Maybe even dismissed it. “Managing risk is for the attorneys.” You scoff to yourself.

In actuality, risk is for the professional trader — and that goes double if you’re an options trader. If you want to make a long-term career in trading, then risk is for you. You have to get a handle on how to manage risk. If you don’t, you are going to blow up a trading account, suffer immeasurable losses, and might even swear off the endeavor entirely.

Here is what every professional trader knows about risk that you may not.

1. Risk management is how you get paid

Ultimately, your trading strategy isn’t what gets you paid if your risk management sucks. Why? Trading is all about probabilities.

If you had a trading strategy with profits 70% of the time, you’d probably take it. But overall, that strategy is only profitable if the cumulative gains of the 70% of trades outweighs the losses that you take on 30% of the trades. If you make $100 70% of the time, but lose $250 30% of the time, then you have a trading strategy that is actually a losing strategy. It will lose $500 for every 100 trades, if those trades are equally weighted.

How do you make it a winning strategy? One way would be to better control your risk. If you cap your losses at $200 and this doesn’t impact the percentage win/loss, then you have instantly created a profitable trading strategy. Your new profits are $1,000 on 100 equally-weighted trades.

What got you paid? It wasn’t a change in strategy; it was optimizing the risk management portion of the equation.

No matter how good your strategy is, poor trading risk management will result in trading losses. It’s that simple.

2. Risk management protects against losing everything

This may sound like hyperbole, but most traders at some point will lose their entire trading account. Known as “blowing up,” losing all (or nearly all) of the funds in a trading account is almost a rite of passage. Most traders who have made a career in the business have publicly talked about how they’ve blown up trading accounts. Even a legend like Paul Tudor Jones nearly lost everything early in his career.

As a trader with a profitable strategy (after all, if it isn’t profitable, then why are you trading it), your job is to make sure that after the current trade, you can trade again.

3. Risk management is math

How do you protect against losing it all? Your cumulative losses are less than your cumulative gains. That’s math. And math can help you find out how much you are allowed to risk on any one trade via the Kelly criterion.

The Kelly criterion is a mathematical way to maximize compounded returns. To calculate it, you need your average win size, percentage hit rate, and average loss size. The Kelly criterion says that:

Maximum risk amount = Probability of winning – (Probability of losing / Average amount won)

Probability of winning = Percentage of trades that are profitable
Probability of losing = Percentage of trades that are not profitable
Average amount won = Win size divided by loss size

Let’s look at this in practice: I have a trading strategy that is right 65% of the time and wrong 35% of the time. On average, my winning trades generate $1,000 in profits, while my losing trades generate $1,000 in losses. How much would it be safe to risk on each trade?

Risk amount = 0.65 – (0.35 / (1,000 / 1,000))
Risk amount = 0.65 – (0.35 / 1.0) = 0.65 – 0.35
Risk amount = 0.30 = 30.0%

Mathematically, according to the Kelly criterion, if you wanted to maximize your compounded return, you would risk 30% of your total risk on each position.

If you have $1 million in trading funds, but only will risk 20% actively trading, then you would use the Kelly criterion based on the $200,000 that you are willing to lose. That gives you a maximum loss for any one trade of $60,000 under the above conditions.

Before you go thinking you can risk 30% of your account on a trade, a few important notes.

1. Most traders will use at most a fraction (1/2 or 1/4) of Kelly criterion when calculating risk. If you exceed Kelly or the numbers underlying the equation change (like your strategy all the sudden goes out of favor), then betting a full Kelly can be detrimental.

2. Your estimates for these values need to be cautious. Kelly was made for things like blackjack where you can know the odds based on the cards and cards left in the deck. Trading performance is not that simple. And it can be subject to large fluctuations.

3. The amount you risk varies with each trade. If you can risk 30% of your account and you have a series of losing trades, you have to cut your risk. This is often hard to do in the moment.

4. This is really meant for uncorrelated, sequential occurrences. In markets, positions are often correlated. Additionally, you may have more than one trade on at a time, in which case, you can’t risk 30% on each of those trades.

However, this can give you an interesting framework for analyzing your trading history and ensuring that you don’t blow up your trading account by letting any one trade lose too much.

Taking the Next Step: Options Risk Management

The three rules above are broad tips that will help you prevent blowing up your trading account. Simple, easy-to-avoid “rookie mistakes” — but options trading is a deep rabbit hole, and there’s a lot more inside the basket of options risk management strategies.

For instance, have you ever traded a debit spread? Debit spread risk management comes with its own set of tips that you can use to manage risk, and prevent the unfortunate event where risk becomes danger.

Discover the key tips you must know to exploit risk when trading debit spreads inside this free article.
More of a “covered call salesman”? This may seem like a simple, low-risk maneuver, but don’t be fooled. Professionals use three rolling tactics to maximize their success when trading covered calls.
Uncover three must-know maneuvers for covered call traders inside this free article.

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