Reducing Risk as an Option Trader

There is no sure thing as an option trader when it comes to profits, no matter how much the odds may be on your side. All trading is speculative, but as traders we do our best to improve the odds. But what if there isn’t a setup that matches our criteria for entry? The simple answer is, do not take the trade. But what if your gut is telling you something else? Well, let’s find a way to reduce risk.

Here is a recent example we covered in group coaching class. Take a look at the chart of Tesla Inc. (TSLA) below.

Clearly the stock had been in an uptrend for quite some time and was setting another all-time high. There was no bullish entry even on a smaller time frame because the stock was continuing to climb higher. What if an option trader thinks this pattern will continue for at least a couple for days and may not get an entry? The solution may be to reduce risk in one very simple way…fewer contracts.

Fewer contracts equals less risk. The math is simple. What I like to do when I am taking a gut feeling or more risky trade is to do fewer contracts and maybe risk a little more percentage wise. So instead of risking 25%, I might risk 50%. If I cut my contracts in half, that is not really reducing risk. So many times I will do less than half to try to reduce the overall risk.

So entering the trade below, if you normally do 10 contracts, consider 3 or 4. Take a look at the entry below.

Risking 25% of the ask would be rounded to about 1.20 or $1,200 (1.20 X 10) for 10 contracts. But if you reduced the contract size to 3 and risked 50% of the ask, the total risk drops to approximately 2.40 a contract or $720 (2.40 X 3) for 3 contracts. Of course, the potential profit is reduced too.

Taking a look at the position later that day, you can see that the bull call spread has benefited from a move higher (see below).

Despite only 3 contracts, a profit was made of 1.65 a contract or $495 (1.65 X 3) for the position. Not too bad for less than a day’s work. In addition, risk is off the table.

When in doubt, the best thing to do is not make the trade. But when you understand the risk and can reduce your risk on a trade you feel has some inviting odds, decrease your contract size. The risk manager inside of you will love it.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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