Limiting Your Risk When Buying Options

One of the key benefits to buying options is that you can never lose more than what you paid for them.

Another great benefit is the tremendous leverage that options afford the investor.

Of course, there are downsides too.

Unless you're deep in the money, options will only move by a percentage of the underlying stock's move.

And not only do you need to be right on the direction of the stock, you also have to be right on the size of the move and the timing surrounding it.

Sound complicated? It really isn't.

As with any investment, you need to do your homework. Make sure you research the underlying stock before you put any money on its options.

Once you've decided if you're bullish or bearish (meaning you'll buy a call or a put), determine what your reasonable price target is and the time frame when you think it will happen.

You can then decide which option to buy.

But you'll also need to decide how much you'll invest – and risk.

Too many people put way too much money into options.

Yes, they are comforted by the fact that there is tons of leverage and a limited risk (limited to what you put in). But unfortunately, way too many people find out the hard way that while they did have a limited risk (limited to what they put in), they literally ended up losing everything they invested.

For example: just because you have $5,000 to invest in a stock, does not mean you should invest $5,000 in an option.

Why? Because if a stock goes down, you'll be getting out with a loss, but it likely won't be 100%. (Maybe -5%, -10%, -20% or something like that. But it's rare to get in and watch your stock go to zero overnight.)

But seeing an option expire worthless (going to zero) happens all the time – and it often happens much faster than you think.

So today's article is about how much money to invest in an option so you can help limit your risk.

As a rule of thumb when buying options: I'll look at what the stock would cost me. I would also determine how much money I was willing to lose on that stock, i.e., how low would it have to go for me to lose 'x' amount, or, in other words, the most I was willing to lose.

So at that point, I give myself two choices:

1. If I was only willing to lose 15% on a hypothetical $5,000 investment, that means I was willing to lose $750.

   So I could come up with whatever option strategy I thought was best as long as I invested with no more than $750.

   Why only $750?

   Because that was the maximum amount I was willing to lose on my $5,000 investment.

   Too many people instead think: 'OK, I was going to spend $5,000 on the stock, but I can buy $5,000 worth of options and make 10 times as much (or more) if it hits'. Unfortunately, with these types of options, investors usually lose ALL of the $5,000.

   But by strictly putting in ONLY what you were willing to lose, even if you do end up losing it all, it was smart trade because you managed your risk and you never lost more than what you were truly willing to.

2. If you decide to invest more than you'd prefer to lose, the other alternative is to have the discipline to pull the plug the moment the option(s) have lost that amount.

   Novice option traders will often convince themselves to 'hang on' a little bit longer. This is because the stock still 'looks good' and they want to hang in there – seemingly forgetting that a stock can stay above your support levels until the very end and you can still lose it all because you ran out of time.

   Or maybe they hang on too long because they get hit for more than they expected somewhere along the line, and then say: 'well, it doesn't make sense to sell those options now, I might as well keep them to see if anything happens'. (This is probably the most oft-repeated phrase that precedes the option investor that loses 100% of his premium.)

   Don't be that guy.

If you have the discipline, strategy #2 is fine. But sometimes things can get away from you quickly – even for the more experienced options guy.

The first strategy (#1) is usually the best to use until you get more comfortable in your options trading and risk management.

Options are a fantastic tool and can be a tremendous addition to one's portfolio.

But be smart. Don't put in too much. Pay attention. And stay disciplined.

Next week, I'll walk thru my process of finding optionable trades and my options selection.

In the meantime, you can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.