Risk is a subject one can devote a lifetime to inquire about, and options trading will certainly make up part of that study. Concomitant to survival as an option trader, one needs to be au fait with a number of threats that lay waiting to trap the novice or unwary. Given that survival in order to continue trading is every trader’s paramount objective, the containment of addressable threats is only neglected by the foolish.
Basic option theory reveals that risk is limited when buying options, and unlimited when selling them. The fact that volatility is traded and option positions are hedged does not relieve a trader of this simple fact. Selling options is risky in any language.
Due to this fact, amid the numerous trading opportunities that present themselves around the option markets of the world, those that represent the most value will invariably involve the person benefitting from that value to be selling options. This of course may be in the context of an intricate strategy involving many strikes and types of options, or it can simply be in the form of excessive value being sacrificed by a buyer in order to initiate a position.
The unreflective trader will be presented with this opportunity, and quite understandably react with glee. However, after the value is gratefully accepted, the trader must now convert it into profit. Of course, this can be accomplished by managing the trade, closing it out, or by offsetting the trade through transacting other options.
Still, as the greatest value involves selling options, in the event of additional value opportunities entering the market, that trader will be unable to take advantage of it; they are already fat with risk from previously selling options. In the further event of a large move, the trader may well jeopardize the main objective – survival to continue trading.
In order to avoid this sad turn of events, it will be prudent to affect some insurance beforehand. Bearing in mind that insurance, just like options, comes at a price, the most prudent of insurance will come in the purchase of out of the money protection. Ideally this will be merely a few points for each option, and can be executed efficiently as a combined strangle strategy by purchasing an out of the money put and an out of the money call together at a combined price.
Again, this strategy necessarily means paying away some value in order to be protected, but it will remain an asset that the trader can rely on until expiry. In the meantime the trader will be able to concentrate on trading closer to the money strike prices with larger premiums and greater opportunity for profit. The out of the money options that are acquired will quickly erode to be worthless, but their presence in the portfolio will provide a latent value that only the discerning will appreciate. Trading of at the money options will quickly replenish the insurance expense incurred.
At this point, such a trader is free to exploit the real value in option trading that makes its self apparent. They can participate with confidence as they are protected on either side of the market. In many ways option trading is a constant struggle to emulate one very large and cumbersome butterfly.