Evaluating Your Risk Tolerance
- Investment capital. How much money do you have available to invest? How much do you have committed to long-term growth, and how much can you spare for more adventurous alternatives?
- Personal factors. Your risk tolerance is significantly affected by your age, income, debt level, economic status, job, and job security.
- Your investing experience. How experienced are you as an investor? No matter how much you study investing in theory, you do not really gain market experience until you place real money at risk.
- Type of account. Your risk tolerance depends on how and why you invest and the type of account involved. If you invest in your personal account, you will have greater flexibility than in a retirement account, for example.
- Your personal goals. Every investor's goals ultimately determine how much risk is acceptable. Remember that definition of personal goals should dictate how you invest.
The best investment decisions invariably are made as the result of thorough evaluation of the features of an investment or strategy, the most important being risk. The evaluation process helps you to avoid mistakes and focus attention on what will be beneficial, given your risk tolerance level. The risk evaluation worksheet for option investing in Table below will help you to classify options by degrees of risk.
Smart Investor TipRisk tolerance is reflected in the way you invest. You will have a better chance of succeeding if you ensure that the risks you take are risks you can afford.
Risk Evaluation Worksheet
|Lowest Possible Risk|
|--||Covered call writing|
|--||Put purchase for insurance (long position)|
|--||Call purchase for insurance (short position)|
|-- Long||-- Short|
|--||Uncovered call writing|
|-- Long||-- Short|
|--||Call purchases for income|
|--||Put purchases for income|
Risk evaluation depends on your analysis of potential profits and losses under all possible outcomes. When considering an option strategy of any nature, first calculate potential profits in the event of expiration or exercise, and then set criteria for other features: maximum time value, time until expiration, the number of contracts involved in the transaction, target rate of return, and the price range at which you will close. Obviously, these criteria will be drastically different for buyers than for sellers, and for covered versus uncovered option writing. Use the option limits worksheet in Table below to set your personal limits.
|Covered Call Sale Criteria|
|Rate of Return If Unchanged|
|Call premium||Total||$ --|
|Cost of stock||$ --|
|Rate of Return If Exercised|
|Stock gain||--||Total||$ --|
|Cost of stock||$ -- +|
|Option Purchase Criteria|
|Maximum time value: -- %|
|Time until expiration: -- months|
|Number of options: -- contracts|
|Target rate of return: -- %|
|Sell level: increase to $ -- or decrease to $ --|
By Michael C. Thomsett