Options trading offers a potential investment avenue with significant opportunities for growth and portfolio diversification. However, like all investing, options trading carries risks and ensuring you know what these risks are and how to navigate them is a must! This article will explore and help investors get a broad understanding of options risk/reward profiles, what hedging strategies there are for options and how to manage implied volatility and time decay.
Understanding your risk appetite vs risk tolerance
No matter what the investment is, as an investor, it is important to know and understand your risk appetite and risk tolerance. Risk appetite is the amount of risk you as an investor are willing to take to achieve your investment goals. This is more based on a set of attitudes and objectives you have as an investor.
Risk tolerance, on the other hand, is more of a practical approach. It is the measure or degree to which you as an investor are willing to accept risk in your investment portfolio. Risk tolerance can range from aggressive (high risk-willing to lose money to make money) to conservative (little to no volatility in the portfolio). There are a few ways in which you can assess what your risk tolerance is. This can be done through questionnaires, conducting a financial health check, speaking to a financial adviser and so on.
Understanding your risk appetite and tolerance works hand in hand with understanding risk management strategies for you to reach a comfortable level of investing in options.
Understanding options risk/reward profiles
The risk/reward profile is a framework that evaluates the potential loss (risk) and expected return (reward) of a trade or investment. It helps investors assess whether a particular opportunity aligns with their financial goals and risk tolerance.
An option's risk/reward profile is influenced by key factors such as volatility, time to expiration, and strike price. Volatile assets typically have higher premiums and greater risk/reward potential, offering opportunities for potentially higher returns but with increased risk of loss. Similarly, options with longer expiration times provide more opportunities for favourable price movements, enhancing their risk/reward profile. Strike prices far from the current market price may yield greater potential rewards but carry a higher likelihood of expiring worthless. Evaluating these elements is essential for understanding and managing the balance between risk and reward in options trading.
The risk/reward ratio helps quantify the potential risk relative to expected profit. It is calculated as:
Potential loss / potential profit = risk/reward ratio
For example, a 1:2 ratio implies risking $100 to potentially earn $200. Risk/reward ratios commonly range from 1:2 to 1:5, with anything below 1:2 considered highly speculative and above 1:5 deemed conservative.
Traders should choose strategies that align with their personal risk tolerance and trading goals. Novices may prefer conservative ratios (e.g., 1:3 or higher), while seasoned traders with robust strategies might opt for more aggressive approaches. Periodic reassessment of risk tolerance is crucial to ensure it reflects current financial objectives and market conditions.
Understanding an option’s risk/reward profile help to equip investors to make calculated decisions, optimise returns, and minimise unnecessary exposure to risk.
Hedging strategies using options
Hedging with options is a key risk management technique that helps investors reduce potential losses due to unfavourable market movements. By employing strategic positions in options, investors can protect their portfolios while maintaining some exposure to upside potential. Below are some of the most commonly used option hedging strategies:
Protective Put
A protective put, or "married put", involves purchasing put options for an asset already owned. This strategy safeguards against potential declines in the asset's value. If the price drops below the strike price, the put option can be exercised to sell the asset at a predetermined price, limiting losses. This is especially useful for investors who remain bullish on an asset but want downside protection.
Example: If a stock is trading at $50, purchasing a put option with a strike price of $48 ensures the stock can be sold at $48, even if its price falls below that level. And if the stock rallies, the investor can take part in the upside gain.
Covered Call
A covered call strategy involves holding an asset and simultaneously selling call options on it. This generates income from the option premium and is effective in neutral or mildly bullish markets. However, if the stock price rises above the strike price, the investor may be obligated to sell the asset, limiting potential gains.
You can learn more about this strategy in our previous blog.
Collar Strategy
A collar combines a protective put and a covered call. This approach sets a price range for the asset by purchasing a put option for downside protection and selling a call option to offset the put's cost. It is more ideal for investors seeking balanced risk and reward in moderately volatile markets.
Example: If a stock trades at $50, buying a $48 put option and selling a $55 call option creates a price range where losses are limited below $48, and gains are capped above $55.
Long Straddle
A long straddle involves buying a long call option and a long put option at the same strike price for the same expiration date. A long straddle involves buying a call and a put option at the same strike price and expiration, typically at-the-money. It can also be set up above or below the stock price to create a bullish or bearish bias. This strategy profits from significant price movements in either direction and is useful in highly volatile markets.
Managing implied volatility and time decay
Implied volatility (IV) and time decay are pivotal in shaping the pricing and profitability of options. A comprehensive understanding of these factors enables traders to develop effective strategies for potentially maximising returns and reducing risks.
Implied Volatility (IV)
To protect your portfolio and succeed in the long run, volatility-based options trading requires efficient risk management. While using stop-loss orders enable traders to limit possible losses by automatically leaving positions when they reach certain criteria, diversifying investments over a wide range of assets and sectors helps lessen exposure to specific market risks.
Implied volatility (IV) is a key factor in options trading because it affects the price of options. It's a forward-looking measure of the market's expectation of how much a stock price will change before the option expires.
Time Decay
Time decay represents the loss of an option's value due to the passage of time. This effect accelerates as expiry approaches, particularly for out-of-the-money options.
Reducing time decay:
The longer the option has until expiry, the more time that is given to the underlying asset to rise or fall the desired way, as a result the additional time decay becomes less of an influence. Techniques such as credit spreads and debit spreads regulate the decay process by the adjustment needed by the combination of the long and short positions having the same expiration but different strike prices. These involve options with different expirations, for example, the simultaneous purchase of a call option for a longer period and selling a short-dated call allowing traders to benefit from directional trends while offsetting time decay.
Using time decay:
Investors who look for fast earnings can use short-term options, which will be detrimental due to the rapid time decay of the instrument, which will be accepted as part of the strategy. The sale options, like covered calls, give a trader a chance to make some money on time decay by collecting some premiums on the options that lose value.
As time decay accelerates towards expiry, options sellers should sell short-dated options while buyers should buy longer-dated options as they have more time for the price to move in the desired direction.
Visit our Options Trading page on the website to explore more opportunities. Join Tiger Trade and practice options trading with no real capital risk by using the Tiger Trade demo account. Plus, if you open an account, you'll get four $0 brokerage monthly trades on ASX US stocks & ETFs or US options.*
*New clients & unfunded existing clients only. Only min. brokerage waived for 4 ASX, US stocks & ETFs or options trades. Third-party fees and other fees still apply. See T&Cs for details.
Capital at risk. Options trading carries high level of risk and may not be suitable for all investors. You should only trade with money you can afford to lose. See FSG, PDS, TMD and T&Cs via our website before trading. Information provided may contain general advice without taking into account your objectives, financial situations or needs. Past performance is no guarantee of future results. Graphics and charts are for illustrative purpose only. Tiger Brokers (AU) Pty Limited. ABN 12 007 268 386 AFSL 300767
