How to Find the Right Options Trade for Your Risk and Capital

Learn how to find an options trade that fits your capital and risk tolerance using probability, premium, expiration, liquidity, and market conditions.

The first step when looking at an options trade should be to ask yourself whether the trade suits your capital and your level of risk tolerance. There's a tendency to go through an options chain, identify a high premium, and then assume that the opportunity offering the greatest credit must be the most appealing one. However, the premium is only one aspect of the situation. An option that produces $300 might seem interesting by itself, but the same $300 can mean very different things if the amount of capital required is $3,000 rather than $30,000. The SEC states that options are derivatives in that their value is linked to an underlying asset and that options trading can involve considerable risk, so it is especially important to understand the position before entering into it. The same trading options can lead to quite different decisions when made by two traders. One trader might be willing to hold 100 shares of a stock after having sold a put, whereas another might have no desire at all to own the stock. One trader may have $5,000 to use for options trading, while the other has $50,000. Their objectives, the sizes of their positions, their time horizons, and their capacity to absorb a loss are all different. This is the reason why a systematic approach to the analysis of options trade s can be more useful than simply looking for the highest premium or the highest probability figure. Why Capital and Risk Matter When Choosing an Options Trade The amount of capital you have sets a natural limit on the positions you might reasonably take. For instance, a cash-secured put would require enough cash to buy 100 shares if the option is assigned. Since a $40 strike price means that one standard equity contract covers 100 shares, the cash liability in the event of assignment can be large. Although the premium received lowers the actual cost of the shares, it does not get rid of the risk involved in the underlying stock. The Options Industry Council defines a cash-secured put as a strategy in which the trader sets aside the cash necessary to purchase the stock should assignment take place. The amount of capital you allocate to each position is just as important. For example, if you have a $5,000 account and come across a trade that would require about $4,500 of your capital, even if the premium seems attractive, putting the majority of your account into a single position leaves little room for other opportunities or for unexpected changes in the market. With a $50,000 account, a trader has more scope in which to spread their capital among different positions, but that does not mean that larger positions are therefore suitable. The process of managing options risk starts with determining how much capital you are willing to risk before you look at a specific contract. Account Size vs. Capital Allocated The difference between the total value of your account and the amount you decide to assign to one trade is important. For example, a trader might have $20,00