From simple to complex, there are several excellent ways for traders of all ability levels to manage risk. It’s a part of financial life that no matter what kind of instruments you trade, risk is part of the scenery. That’s why the literature talks about a risk-reward ratio. The general goal is to minimize risk while maximizing rewards. Whether you’re a beginner who occasionally buys or sells a few shares of stock, or are a seasoned pro who invests thousands of dollars each week into options, futures, commodities, and other instruments, your eye should always be on the risk-reward ratio.
When it comes to keeping your investments safe, there are many strategies, some more effective than others. However, the following five represent a sort of evolution, from simplest to more complex. If you’re new to the markets, consider the first three or four on the list. If you have more than a year of active trading under your belt, you’ll be comfortable with any of the five.
If you identify an attractive trade and decide to put your money on the line, how much should you spend? The size of your position can be calculated easily if you have a rule in place. Many investors limit their buys to no more than two percent of available trading capital. So, if your account has $30,000 in it, and you spot a security that is ready to move in price, your maximum buying power would be $600 for that particular deal. Position sizing is one of the core principles that protects new traders from blowing up their accounts, i.e., going broke.
Once you begin to master the various kinds of orders, stops will likely become your favorite. They’re easy to understand and simple to put into practice. Simply put, a stop order tells the brokerage platform that you want to either buy or sell a security when the market price reaches a given point. For example, if you own 1,000 shares of ABC stock and want to sell when it drops below $40, you’d place a stop order for $40. If things go bad for ABC and prices start to sink, you’re able to get out before values get far below that $40 mark.
Limits are like stops but are used in quite different ways. When you place a limit order, you’re telling the platform to buy or sell for you whenever the security’s price reaches a specific point, or better.
A buy limit at $50 on ABC would mean is the price rises above that level, your purchase would automatically go into effect, thus getting you in on the action well before prices rise higher.
Hedging with Opposite Options
Advanced practitioners use hedging to limit losses. For example, someone who purchases 1,000 shares of a stock might simultaneously buy a small number of options on that same stock. The deal is arranged so that if the share price goes down, the value of the option goes up. So, if circumstances go against you on one side, the other side saves you from a complete washout. Another, more effective example is the Ava protect hedging feature. For a small upfront premium, you don’t have to worry about a position going against you. If an options trade goes bad, you are protected against losses, within a certain time frame, of up to $1 million. This is just one example of the way some modern trading platforms work with people who want more protection from losses. The Ava Protect feature takes risk-management to a completely automatic level and offers an unprecedented level of risk management.
Complex Options Strategies
It’s easy to see how the goal of minimizing risk within a series of related options trades can become mathematically complex in a short period of time. If you’re at ease with these kinds of involved, highly analytical kinds of strategies, consider using a few of the advanced techniques like straddles, butterflies, covered calls, married puts, bull call spreads, bear put spreads, long strangles, long-call butterfly spreads, protective collars, iron condors, iron butterflies, and more. There are hundreds of them, each with a more intriguing name than the last.
For example, here’s how a long strangle works: purchase two out-of-the-money options on the same asset. Make sure expiration dates are the same. One is a call and the other is a put. The long strangle works well when you know there will be some big news about the company coming out soon. However, you’re not sure whether the news will be positive or negative. Since your losses are limited by gains are not, you simply wait for the news to break and watch which direction the stock’s price moves. As long as the move is significant, you’ll be able to cover your initial costs and net a decent profit.