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OPTIONS RISK MANAGEMENT

Core Concept: Options risk management defines position sizing, loss limits, and exit rules to preserve capital.

Why It Matters

Options can result in total loss. 90% of options expire worthless. Systematic risk management prevents account blow-up.

When to Use

✅ Always:

• Before entering any trade
• When position moves against you
• At position review intervals
• During market regime changes

❌ Never:

• Trade without defined max loss
• Risk more than you can afford to lose
• Skip stop losses "just this once"

Core Rules

Position sizing: Never risk more than 1-2% of account per trade
Example: $50k account → Max $500-1,000 risk per trade

Stop loss: Exit at 50% loss of premium paid
Don't "hope" options recover near expiration

Win rate reality: 30-40% is normal for directional trades
Need 2:1 or 3:1 win:loss ratio to be profitable

Portfolio allocation: Max 5-10% of portfolio in options
Rest in stocks/ETFs/cash

Trade-offs

Strict rules: Fewer losses, lower stress, sustainable long-term
Loose rules: Occasional big wins, frequent blow-ups, unsustainable

This builds on options_basics for understanding risk and connects to options_position_sizing for implementation.

Quick Reference

Risk Type	Mitigation	Example
Total loss	Defined risk trades only	Spreads vs naked calls
Time decay	Avoid < 30 DTE for long options	Buy 60-90 DTE minimum
IV crush	Check IVR before earnings	Avoid buying > 80 IVR
Assignment	Monitor ITM short options	Close or roll before expiration
Concentration	Max 3-5 positions at once	Don't overtrade
Liquidity	Trade liquid underlyings only	Bid-ask spread < $0.10

Red flags to avoid:

• 0DTE or weekly options (high gamma risk)
• Illiquid stocks (wide spreads, hard to exit)
• Naked short options (unlimited loss potential)
• Revenge trading (emotional decisions)

Checklist before entry:

• Max loss defined and acceptable (< 2% account)
• IV rank checked (avoid extreme highs for buying)
• Liquidity adequate (volume > 100/day open interest)
• Exit plan documented (profit target + stop loss)
• Greeks reviewed (theta, delta make sense)

Examples

EXAMPLE

Position sizing calculation:

Account: $50,000
Risk tolerance: 1.5% per trade = $750

Trade: Buy AAPL 180 Call at $5.00
Max loss per contract: $500

Max contracts: $750 / $500 = 1.5 → Buy 1 contract

Never: "This feels like a sure thing, I'll buy 5 contracts"
That's $2,500 risk (5% of account) - too concentrated.

Stop loss discipline:

Entry: Buy SPY 450 Call for $8.00 ($800)
Stop loss: 50% = $4.00 ($400)

Day 3: Option at $3.50
→ Exit immediately, accept $450 loss

Day 7: Option expires worthless
Lesson: Stop loss saved $350 (44% of position)

Diversification across time:

Wrong:

• 5 positions, all expiring same week
• Correlated risk (theta crush hits all at once)

Right:

• Position 1: 45 DTE
• Position 2: 60 DTE
• Position 3: 90 DTE
• Staggers theta decay and rolling opportunities

Kelly Criterion for sizing:

Formula: f = (bp - q) / b

• b = win:loss ratio
• p = win probability
• q = loss probability

Example: 40% win rate, 2:1 win:loss
f = (2 × 0.4 - 0.6) / 2 = 0.1 → Risk 10% of bankroll

But in options: Use 25-50% of Kelly (aggressive even)
→ 2.5-5% per trade max

Portfolio heat example:

Account: $50,000

Current positions:

• Trade 1: $500 at risk (1%)
• Trade 2: $750 at risk (1.5%)
• Trade 3: $400 at risk (0.8%)

Total heat: $1,650 (3.3%)

Rule: If total heat > 5%, no new positions until one closes. ```

References

• "Trade Your Way to Financial Freedom" by Van Tharp (position sizing)
• tastytrade: Risk Management
• "The New Trading for a Living" by Dr. Alexander Elder