The winners in options trading are those who manage the risk within their portfolio. You must always monitor and protect your capital as if you lose your capital you will be out of the game. Proper risk management starts with trading diversification and discipline to stick with your trading plan.
There are generally two types of portfolio risk: systematic and unsystematic.
Systematic Risk, also called non-diversifiable risk, is risk that cannot be eliminated. It arises from factors which cause the whole market to move up or down, and can not be eliminated by diversification because it affects all securities. Examples of systematic risk are political or sociological changes that affect all securities. Some of the most common forms of systematic risk are changes in interest rates or inflation.
Unsystematic Risk, also called diversifiable risk can be reduced or eliminated by diversifying your portfolio. Unsystematic risk is risk that is unique to a certain industry, firm, or company. Examples of unsystematic risk include: a company’s financial structure, weather and natural disasters, labor strife and a shortage of raw materials. Since unsystematic risk affects a single company or industry, it can be mitigated by investing in many companies across a broad range of industries.
Option positions should be diversified. A major advantage of option purchases is ‘truncated risk’, whereby your loss is limited to your initial investment yet your profit is virtually unlimited. Option sells have a limited profit but should be diversified across several investments. Diversification will allow you to use truncated risk to its maximum advantage. While some of your positions will inevitably be unprofitable, each profitable trade can offset several unprofitable trades. Option positions should be established among many underlying stocks and indexes in unrelated industries. This gives you diversification, which can help mitigate sector weakness.