If you’re an options trader like me, you know that we have tremendous leverage trading options versus stocks. But unless you understand options risk management, that leverage only goes so far.
You will have a better chance of winning big and losing smaller amounts of capital if you combine these factors:
- Probabilities
- Delta
- Volatility
- Time expiration
If you’re new to options trading, you can’t just wing it. I don’t know of anyone who can make a living by placing trades with low probability of profits. You might as well gamble in a casino.
You need a process that consistently positions you to make money or lose less money if a trade does not work in your favor.
Probabilities are crucial to options risk management
Each option has a certain probability of making it to the strike price, which is often measured through the delta.
Deltas are unique for each strike based on expiration. For the purposes of learning how to manage options risk, it’s important to know the higher the delta, the better the chances that stock will hit a strike price before the option expires.
Therefore, there is intrinsic value in a call option if the stock price is above the strike price. This is called “moneyness.” If the stock price is below the strike price, then the only value in that option is time.
If you’re going to buy time, you’re trading on the hope that the stock price moves faster than the option price. (This is called gamma, or rate of change in delta.
Buying a higher probability option allows you to stay with a trade for a longer period, even if you give up some leverage and help with risk management.
If you’re scratching your head wondering what I just said, let me explain.
Here’s how options risk management works in real life
Let’s say Amazon is trading at $138 per share. You think the stock may move higher, so rather than buying shares, you buy call options for the leverage.
You have many strike choices to choose from, so let’s compare an out-of-the-money $140 strike to an in-the-money $135 strike, six weeks out.
- The 135 strike costs $7.65 per contract, or $765 for one stock.
- The $140 call strike costs $4.85 per contract, or $485 for one stock.
- The difference in stock price is $280, and most of that differential is due to time.
What are the probabilities Amazon is above each strike price in six weeks?
- The 135 strike has a delta of 62% while the 140 strike carries a delta of 48%. So now we know that the 135 strike has a better chance of making it through 135 in six weeks.
- The 140 call still has a chance to make it, but it’ll require a bit more heavy lifting since it is out of the money.
Additionally, the 140 call at 4.85 has ZERO intrinsic value, but the 135 call has $3 of intrinsic value.
The value of both calls will decay in a similar fashion, but the value of the 140 strike will move faster to the downside if the stock remains stable or even drops a bit.
Therefore, the 135 strike has a better probability of hitting or passing the strike price.
TL/DR
Clear as mud, right? (If you need an overview of options trading basics, you can find it here.)
When all is said and done, the safer trade is in the money with the higher delta. Of course, you still have to wait for the outcome. If it’s in your favor, then you manage risk by taking profits when you have them.
Learning how – and when – to sell is a key part of options risk management, so take advantage of my ebook, The Art of Selling, to help you improve your profitability.
