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Risk Management
What does risk management mean in trading?
Risk management means deciding how much capital to risk, where risk begins, and what action to take if the trade moves against the plan. It is one of the most important parts of trading.
Example:
A trader may decide not to risk more than a certain percentage of their account on any single trade. If they have $100,000 in their account and only want to risk 10% of that for options, that would be $10,000.
Why is defined risk important?
Defined risk means the maximum potential loss is known before entering the trade. This does not make the trade safe, but it helps the trader understand the possible downside. If one believes that they would lose sleep over losing the amount at risk, that amount is too much.
Example:
A $5-wide credit spread opened for $1.00 has a theoretical max loss of $4.00 per share, or $400 per contract before commissions and fees.
What is the difference between risk and probability?
A trade can have a high probability of profit but still carry meaningful risk. Probability describes the chance of an outcome. Risk describes what can be lost if the trade does not work.
Example:
A credit spread may have a high probability of expiring worthless, but if the position moves sharply against the trader, the loss can still be larger than the credit received.
Why should traders avoid risking too much on one trade?
Even good strategies can experience losing trades. Risking too much on one position can make it difficult to recover from a loss.
Example:
If a trader risks 50% of their account on one trade, one bad outcome can cause major account damage. If the trader risks a smaller portion, losses may be easier to manage.
What is a stop-loss?
A stop-loss is a planned exit point used to limit losses. In options trading, stop-losses can be more complex because option prices are affected by volatility, time decay, bid/ask spreads, and market speed.
Example:
A trader may decide to exit a credit spread if the position reaches a certain loss level or if the underlying breaks a specific technical level.
Key takeaway
Risk management is not about avoiding all losses. It is about planning for losses before they happen and making sure one trade does not control the entire account.