Managing the risk of Option Selling

Most people do not look at the risk of option selling. They are lured to options because of their huge profit potential, but often times do so without creating a plan of action for when they are wrong.

Few realize that even though selling options can come with high success rates you still need to manage your risk. Just being right the majority of the time isn’t going to make you an automatic Stock Market success story.

Cases in Point look at iron condors. An iron condor is a high probability trade but offers a huge risk when compared to its reward. For instance you may sell an iron condor between $400 and $300 and make a premium of $1.5.

It would be a high probability trade, because the stock only needs to stay between $300 and $400 for you to be profitable. But you may be risking $8.5 to make that $1.5.

Now let’s do the Math, shall we. If you are right 80% of the time and made $1.5 you would make $1.5*(.8) or $1.2 on average.

If you are wrong 20% of the time and lose an average of $8.5 when you are wrong you would lose $8.5*(.2) or $1.7 on average.

That means you would be losing an average of $1.7 - $1.2 or $.50 per trade if you did not manage your risk. Now my goal isn’t to scare you away from trading the iron condor, it can be a great strategy and allow you to make a great income from the market.

But you have to realize there is risk and that risk should be managed if you want to make it as a trader. Instead of that say we decided to cut our losses at $2. Well we might be right a little less, but we will have significantly lowered our risk. That could tip the scale in our favor. Cutting losses has to be at the front of your mind when trading.

Too many people focus on profits only, and that is why they fail.