Risk Management with Options
Options for money management make a lot of sense but require significant study, experience, and discipline for the strategy to work properly. There are three basic strategies for money management with options but dozens of permutations on them. Remember, no matter how sophisticated your strategy is, you still must be correct about the price movement of an option to make a profit. There is no magic in the torturing of the numbers, friend.
These four strategies are based on long the EUR/USD.
- ;Strategy 1: Perhaps you entered a market with extremely high volatility; long the Euro, short the U.S. Dollar (EUR/USD) just before an important news announcement is due.
- Strategy 2: Perhaps you have a long-term trade in mind and plan to hold the position over several days. A put helps anchor your position against the risks and vagaries of a long-term hold. In FOREX, the risks associated with long hold periods are substantial.
- Strategy 3: In this scenario of a long-term hold, you could write a call against your position and collect income during the holding time from the purchaser of the call. You must calculate the value of the income versus the risk of having your spot position called away from you.
- Strategy 4: You find a great trade, but the stop-loss would be too far away for your trading profile or perhaps a new report is pending. You can sell the spot pair and simultaneously buy a call option. As soon as your primary trade (the spot pair) reaches a point at which you can place a break-even stop-loss, you cover (sell) the call option. You will lose some money on the option but if the pair performs according to your expectations, then being able to take the trade justifies the cost. See Figure below.
Options are relatively expensive. You might think a good strategy would be buying both a short-term call and a put before a big news announcement. If prices move dramatically, the profit on one will more than compensate for the loss on the other. Others have also considered the idea. Option prices spike before such events, making a profit unlikely, except for a quite extraordinary price move. There is no free lunch; sophisticated traders and researchers have almost certainly already studied or tried any strategy you may discover. Said another way -- the markets are efficient.
Because of the complex matrix of possibilities, options have probably come under more mathematical scrutiny than any other investment vehicle.