Option traders have to manage risk. Want a job description? That’s about it. Every trade has a risk and reward associated with it and traders must realize that especially when first learning how to trade. Because options are instruments of leverage, it is very easy to let risk get out of control, if you’re not careful. Traders must manage risk carefully, instituting tight reins on their options, spreads and portfolio. The management technique of each is essentially the same because position management is fractal.
Something that is fractal has a recurring pattern that has continuity within its scale. For example, a tree is fractal. A tree has a trunk with limbs extending from it; limbs with smaller branches extending from it; smaller branches with yet smaller branches; and leaves with veins that branch off within each leaf. The pattern is repetitive within each iteratively smaller extension of the last. This is found in option position management too.
Individual options have risk that must be managed. They have direction, time and volatility risk which are managed by setting thresholds for each of the corresponding greeks which measure them. When individual options are a part of a spread, the resulting spread has these same risks of direction time and volatility. The spread’s risk must consequently be managed likewise. A trader’s complete option portfolio, which may be comprised of many spreads has systematic risk in accordance to the market. These risks are the same as for individual options or individual spreads: direction, time and volatility. Traders should treat their all encompassing portfolio as a single spread and use the portfolio greeks to set parameters to minimize the total risk of the portfolio.
Senior Options Instructor