Trading options can be quite dangerous, especially for new prospective traders who don’t have a clear realization of the risks of trading generally and specifically the risks of options trading. Some novice investors put all their money in one stock and they are hoping that its price will rise, without applying certain rules of risk management. This is a ”buy and hope” strategy which results in the long term in a 70%-100% loss of the initial capital most of the times.

Imagine an investor who invests all his/her money (i.e. $30.000) in options which expire in three months. Then in three months he/she might have lost permanently all initial capital and this demonstrates the inherent risk of options trading. Also brokers in order to control the risk of writing options are demanding from their clients a quite high margin depending on the risk of the strategy.

In options trading only a small part of the initial capital should be risked in every trade and as in every tradable instrument the trader must close his/her position if they change their mind about market/option conditions or if  things go wrong, in order to minimize losses. The problem here is that most of the times options spreads are not 1 cent, just like in many stocks, but 5-10 cents at least, so active management of the position and the exit strategy using stops is less effective and it might result in more losses than anticipated.

Technical analysis of the underline security chart is also a prerequisite in order to have a clue about the possible movement of the stock and accordingly the appropriate strategy that should be applied.

Generally, before the opening of an options position someone must have a good understanding of three elements:

1. The maximum loss/profit of the strategy if held until expiration

 This is a way to estimate the inherent risk of the position. Profit diagrams can also be useful for this purpose.  

2. What strategy to use in which market conditions

Depending on the expectations of the trader and the stock or market circumstances a different strategy might be appropriate.

3. How high or low is the implied volatility of the option

Depending on implied volatility and the trader’s expectations a different strategy might be appropriate. A whole set of strategies have been developed in order to profit from the rising or declining of implied volatility.