Risk should always be considered when it comes to trading. However, there are ways to minimise risk, and options can be one of those methods. We will explore how options can reduce the amount of risk in your trading portfolio. We will also discuss the types of risks that options can help you avoid and provide tips on how to use them to protect your investments.
For more information on trading options, you can check out Saxo Capital Markets.
How to use options to reduce risk in your trades
Now that you know a little bit more about options, let’s discuss how they can be used to reduce risk in your trades.
Investors often use these to hedge their portfolios against potential losses. Investors can limit their downside risk by buying options while maintaining upside potential. If you own shares of XYZ Company and are worried about a potential drop in the stock price, you could buy a put option to protect your investment. If the price falls, you can exercise your option and sell your shares at the strike price, the price at which the option was purchased. This way, you would limit your losses to the premium paid for the option.
Similarly, options can also speculate on the future direction of an asset’s price. For example, if you think the stock price of XYZ Company is going to rise, you could buy a call option. If the price increases, you can exercise your option and buy the shares at the strike price. Now, you can sell them for a profit.
However, if the stock price doesn’t rise, you would let the option expire and only lose the premium paid for the option.
The risks of options trading and how to minimise those risks
While options offer many benefits, some risks are associated with options trading. The most common risks are:
Volatility is the amount by which an asset’s price fluctuates. When volatility is high, it means there is a greater chance for the price of an asset to move in either direction. It can be a risk because it makes it difficult to predict where the price will go. However, there are ways to minimise this risk.
One way is to trade options with shorter expiry times. This way, you’ll not be exposed to the asset’s price fluctuations for as long and will have a better chance of making a profit. Another way to reduce volatility risk is to trade options with a lower premium. It means that you will not have to pay as much for the option, but it also means that your potential profit will be lower.
Time decay risk
Time decay is the risk that an option will lose its value over time. It is because options are wasted, making them less valuable as they approach their expiry date. It is because there is less time for the underlying asset’s price to move in the direction you want it to. However, there are ways to minimise this risk.
One way is to trade options with longer expiry times. This way, you’ll not have to worry about the option losing its value as quickly. Another way to reduce time decay risk is to trade options with a higher premium. It means that you will have to pay more for the option, but it also means that your potential profit will be higher.
It is the risk that you will not be able to find a buyer for your option when you want to sell it. It could be a problem if you need to sell the option to make a profit or limit your losses. However, there are ways to minimise this risk.
One way is to trade options on assets that are highly liquid. It means that there are many buyers and sellers of the asset, and it is easy to find someone who wants to buy or sell. Another way to reduce liquidity risk is to trade options with a lower premium. More people will be willing to buy the option from you because it is less expensive.
Options are a versatile tool that can be used in many ways to reduce risk in your trades. However, it’s essential to remember that options are a complex financial instrument and must be carefully understood before they are used. If you are unsure how to use options or are new to trading, it is always best to seek professional advice.