How to Minimize Option Trading Risk
By: Billy Williams
One of the main advantages of options is the ability to minimize option trading risk. When I buy an option, I automatically limit my risk to the amount of money I paid for those options.
However, when I sell an option, I expose myself to virtually unlimited risk. Some traders consider selling options too risky. However, selling options also happens to be one of the best ways to make money with options.
Identifying risk with options
Options spread trading requires selling calls and puts frequently. The key to controlling the risk with selling calls and puts is proper trade setup, understanding the technicals of the underlying security and understanding the risks of the trade from all angles. The strategy is to minimize the risk of each trade by protecting ourselves with the option spread strategies discussed in this and related articles.
Selling options can be set up properly in the form of calls or puts to manage risk in pursuit of profitable trades. The aspect of option trading dealing with risks of options concerns the two terms known as exercising and assignment.
Exercising an option means that the person holding the option decides to use it. If I sell a call and the buyer decides to exercise the call, I must deliver the stock or the underlying security to the buyer as the option dictates.
Assignment is when the seller of the option is called to fulfill the obligation defined by the option contract. The person or institution that wrote the option is said to be assigned to deliver on the terms of the options contract. According to the options clearinghouse data, about 17% to 20% of options have been exercised historically.
Surprisingly, I have never had an option exercised, and I have never had an option assigned to me. Part of the reason for my good luck at avoiding exercising and assignment is that I tend to trade options in the commodities market rather than in the stock market. Because of physical inventory implications in the commodities market, the other side of those trades has no interest in taking delivery on large futures contracts. If you are trading in the stock market, you must take assignment and exercise into consideration in your trading setups.
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