Feeling that money tingle and want to YOLO some options? I won’t do it, but hey, it’s your money. You can make 100x in a short period of time, or you can lose every penny – it’s your decision. But what about if you want to limit your risk when buying options, even if just a little bit? Well, there are some, ahem, options. Let’s take a look.
How to Limit Your Risk When Buying Options
How Do Options Work?
I’m not going to type this out. I can guarantee you that your eyes will glaze over. But here’s what I will do: embed a nice video that explains it all:
You can also find a great explanation here.
What Is Your Risk?
Simple: you can lose all of your money, down to zero. You might ask if this is not the same risk you take when buying stocks. The answer is yes and no.
You see, when buying stocks, you can theoretically lose all your money, too. But it’s far less likely, for several big reasons.
Mainly, stocks don’t have an expiration date, as options do. As long as the stock continues to be publicly traded, you can hold on to a losing long position forever. It may go up and you may end up with a profit, or you can sell it at a loss. But even if you sell at a loss, you don’t lose all of your money. Only part of it. As a matter of fact, even if the company goes bankrupt and the stock goes to zero, you still may have some rights to company assets as a shareholder.
Compare with call options, which have an expiration date. If they expire out of the money (where the price of the underlying stock is below the strike price of the option), you will lose it all.
Of course, that’s the dark side of options. The other face of the coin, and the reason they can be so attractive, is that a good bet on options can make you a literal fortune. I’m talking about 50x your money, or even much more.
The potential for loss is the reason that I personally rarely buy options. I’m really not a YOLO, diamond-hands type. I’m more of a buy-and-hold investor and day trader. But, I still love the whole options game and know a thing or two about managing risk as a day trader. Here’s how you can manage some of the risk of options if you’re a YOLO-er.
3 Ways to Limit Your Risk
Diversify Your Option Buys
Limit your risk when buying stock options simply by not YOLO-ing it all on one stock. In other words, buy options for different stocks. If you must buy $10,000 of calls, why do it all with the same stock? It’s better to buy $1,000 of 10 stocks than $10,000 of one.
It’s still risky, but even if one of those bets pays off big you can still come out ahead in the end.
By this, I mean scale in over time. Rather than making one big bet, spread it out. If you’re going to devote $10,000 to this endeavor, don’t use it up all at once. Instead, buy $2,500 per month over four months.
This is a great technique from day trading. What you do is take profits on a winning position over time. For example, say you YOLO $10,000 on 10 calls and it works out. Instead of holding until expiration and risking a price drop and a loss of your gains, scale out. Sell 1 call when you’ve doubled your money, 2 calls when you’ve made 4x, another call at 10x, and so on and so forth. That way, you realize gains and reduce risk.
Summing Up Some Ways to Limit Your Risk When Buying Options
At the end of the day, buying options is still extremely risky, my dudes and dudettes. You can easily lose it all, and then go into the gambler’s rabbit hole: scrounge up some more money, double down, and lose it all again and again until you’re beyond broke. That’s why it’s not my style.
But YOLO-ers are gonna YOLO, so you might as well limit risk and stay in the game longer. If that sounds like a plan, consider diversifying, scaling in, and scaling out. It will at least limit your risk!
Do you limit your risk when buying options?