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Managing Risk
Managing individual investment risk
As demonstrated in the previous section, large investments are more
profitable per dollar risked, but larger trades entail more
risk. For stock portfolios, proponents of diversification recommend
that no more than 5% of your portfolio should be invested in
one stock. Proponents of focused portfolios recommend that no
more than 12% be in one stock. For stock, it is unlikely that
you would lose your entire investment. Option investing provides
leverage and leverage cuts in both directions. Rates of return
are higher, but the probability of losing your entire investment
is also much higher. For this reason, it is recommended that
no more than 1% to 2% of your portfolio be in a specific option
investment.
Contracts
Traded |
Total amount
risked |
Portfolio size at
1% risked |
Portfolio size at
2% risked |
| 5 |
$875 |
$87,500 |
$43,750 |
| 10 |
$1750 |
$175,000 |
$87,500 |
| 50 |
$8750 |
$875,000 |
$437,500 |
Given the 1% to 2% recommendation discussed above, you should not become
active in option investing unless your portfolio is greater than $50,000.
Managing systematic risk
The effects of systematic risk are also amplified. If you are bullish
on the market it’s likely that your investments are bullishly
invested in multiple securities. If you are fully invested in
Bull Spread option positions, a short term broad based bearish
market fluctuation could wipe out a most or all of your portfolio.
Until you master hedging systematic risk, limit your portfolio
to no more than 10 to 20% exposure into these types of option
investments.
Note that certain types of option investments, such as
Covered Calls,
actually reduce portfolio risk (see the discussion of Covered Call
Strategies for the risk discussion of this type of investment).
Diversifying your option portfolio across multiple industry sectors
and multiple expiration dates significantly helps in reducing your systematic
risk. Professional investment houses use sophisticated portfolio modeling
tools to measure and reduce systematic risk.
Next Section: Evaluating Option Investment Opportunities
Previous Section: Critical mass - (It takes money to make money)
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