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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.
Total amount
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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