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Risk Management Strategies - Risk graph!

Options Trading

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What is it?

One of the greatest advantages of the options market is risk management. The risk graph can help you to analyze the risks, so it is important to get familiar with it and to be able to use it.

Many people start live options trading without any idea about risk graphs and how to analyze them. In this article, I will explain how risk graphs work.

At first, I did not deal with risk graphs either, because the stock market does not require them. That's the big problem.

The risk graph of the stock market (or any underlying product) is "life-threatening". Why? You will soon find out if you read on.

So far, I have spoken to several people who trade shares and they had no idea about risk graphs.

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Long risk graph

Here's the risk graph of a stock purchase order (Long):

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Long risk graph

What's wrong with the graph?

The fact that it carries unlimited risk. I repeat, unlimited risk.

If you look at the graph closely, you can see the following:

the current price is around 390 (GOOG),

the profit - loss curve is linear,

the loss is unlimited, it might go to 0.

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Stop orders

I know that the stop order comes to your mind right now, but think about it once more. Basically, there are two types of stop orders:

STOP Market:-> you close the position at any price you can get for the paper right now,-> if the market opens with a gap, you cannot control where the order will be executed.

STOP limit:-> In case of a gap, the market jumps over the limit price, the stop will not be executed, you are stuck in your position.

Always ask yourself the question, "What do I do if the market goes against me?". What do you do if you see this kind of risk graph? Let's suppose you have a STOP market order at 350. Google opens with a gap the day after, at 300 (does not matter why). Huge losses. You get out. If the same stop order was a limit order too, you do not even get out, the market skipped your STOP.

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The key is managing risks

I would not call any of them appropriate Risk Management!

Greatest strength of the options market is the ability to exactly specify the risk in advance. Many people - wrongly - claim that the options market is risky. 

Of course, if you do not know what you're doing, it is risky. But everything is risky in life, if you do not know what you're doing ...

So, I do not like the above picture. I choose an option contract on the basis of a picture I like. If I do not like the picture, I look for another one - either for another underlying product or for a different options strategy. The key is managing risks, I cannot emphasize this enough.

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Short risk graph

Let's look at what the selling (short) the risk graph of the same paper would look like:

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This is even worse than the previous image because:

if long, the paper could go "only" to zero,

if short, it can rise theoretically to any level.

What would you do if you had a Short opened at 380 and one morning, you wake up and Google opens at 500? If you had a STOP market order, it was executed at 500, that means you suffered a huge loss. I would not call such a big loss planned Risk Management. 

If you had a stop limit order that was opened at 400, the price simply jumped over it, that means you still sit in the position. I would not call this Risk Management either!

Remember, if you do not like the risk graph, you should choose another one. Find a picture that you like, and make the trading decision based on that one.

Short risk graph

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Options strategies have limited risks

The advantage of the options market is the ability to trade with limited risk.

You will no longer be a victim of stop orders. In the following article, you will understand what kind of pictures I like. In other words, what are the risk graphs (options strategies) that have limited risks.

You will soon understand why I love the options market so much. It has trading potentials that are never provided by the simple stock market ...

Lessons learned:

- Never trade without analyzing the risk graph.- If you do not like the picture, look for another one (underlying product or options strategy).

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Feel free to ask me!

Email: gery@optionsrules.comMy webpage: http://www.optionsrules.com/

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Skype: opcioguru