Exploring Option Risk Mitigation

There is option risk associated with hedging a stock position or taking advantage of the movement of a particular stock. Option contracts provide you an opportunity to participate in the market with the lowest capital outlay, but the greatest potential for either profit or loss, depending on the options position you take. You can mitigate this risk by taking opposite positions against your bet or limiting either your upside or downside risk with different options strategies. These strategies help mitigate your risk and maximize your potential gain.

Basis for an Options Strategy

Option strategies are based on your experience and knowledge about trading options. Many of the positions and strategies that will be discussed in this article require approval by a brokerage firm and sufficient capital necessary to cover any losses that may occur as a result of the strategy. You should understand that although this article will discuss these strategies in a very generic tone, there are many complexities regarding risk mitigation strategies that require the counsel and advice of an experienced broker who understands how options work. Do not attempt these strategies on your own without at least meeting the minimum standards or requirements of the brokerage firm that you will be trading with.

Mitigating Options Trading Risk

One way to mitigate the risk of a short option position–that is a position where you sell a call or put contract in order to earn the premium income–is to hedge it with a corresponding long position. This is known as a straddle position. It is aptly named because the straddle gives the impression that you are straddling the fence or both sides of the market. The short position gives you income since you sell the option position for the premium. The long position grants you protection if the stock moves opposite of your bet by putting you in the position of exercising that position before the option expires.

Process for Opening an Options Account

The extent to which you can mitigate risks with an option on an underlying stock is based on your assets, experience and knowledge. These factors are chief considerations that are taken into account by a brokerage firm prior to opening an options account. Under the rules of the various exchanges and the self-regulatory organization for the securities industry–FINRA–as well as the U.S. Securities and Exchange Commission, certain disclosures must be made and information obtained prior to approving an options account for certain levels of risk. The more experience that a client has, the more likely that the level of approval given will exceed that of simply buying calls and puts.

Once it is determined that the client’s profile is sufficient to appreciate the risks associated with trading call and put contracts, the client should sit with their financial adviser or registered representative and map out the appropriate strategy to account for the risks associated with trading options, and the ways to mitigate those risks.

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