Evaluating Your Risk Tolerance

Everyone has a specific level of risk tolerance -- the ability and willingness to accept risk. This trait is not fixed but changes over time. Your personal risk tolerance is influenced by several factors:

Smart Investor Tip

Risk 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.

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.

Risk Evaluation Worksheet

Lowest Possible Risk
-- Covered call writing
-- Put purchase for insurance (long position)
-- Call purchase for insurance (short position)
Medium Risk
-- Ratio writing
-- Combined strategies
-- Long -- Short
High Risk
-- Uncovered call writing
-- Combined strategies
-- 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.

Option Limits

Covered Call Sale Criteria
Rate of Return If Unchanged
Dividends$ --
Call premiumTotal$ --
Cost of stock$ --
Gain -- %
Rate of Return If Exercised
Dividends$ --
Call premium --
Stock gain -- Total$ --
Cost of stock$ -- +
Gain -- %
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
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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