Investors constantly seek new ways to manage risk and protect their investments as the financial landscape evolves. One of the most popular investment vehicles in Singapore is listed options trading. While this form of trading offers an excellent opportunity for investors to generate potential returns, it also comes with risks.
With that in mind, investors need to have a solid understanding of advanced risk management strategies to navigate the volatile options market in Singapore. This article will discuss advanced risk management strategies for listed options trading in Singapore.
Diversification
Diversification is a fundamental risk management strategy that helps investors mitigate potential losses by spreading their investments across different assets. In the context of listed options trading in Singapore, diversification means investing in various options contracts with varying expiration dates, strike prices, and underlying assets.
By diversifying their portfolio of options contracts, investors can reduce their exposure to single-market movements. For instance, if investors allocate all their funds into a single options contract and the underlying asset experiences significant price fluctuations, they will incur substantial losses. However, by diversifying their investments into multiple contracts, investors can offset potential losses from one contract with profits from another.
Diversification allows investors to participate in different market conditions. In other words, if an investor’s portfolio consists of bullish, bearish, and neutral options contracts, they can generate potential returns regardless of the market’s direction. Diversification also helps investors manage their risk appetite. By spreading their investments across different assets with varying levels of risk, investors can adjust their risk exposure according to their risk tolerance.
Hedging
Hedging is a risk management strategy that involves taking on an offsetting position to minimise potential losses. Investors can utilise hedging to protect their portfolios from adverse market movements in the context of listed options trading in Singapore.
One common hedging strategy in listed options trading is protective puts. Protective puts involve purchasing put options contracts on the same underlying asset to limit potential losses. In case the price of the underlying asset drops, investors can exercise their put options and sell their shares at a predetermined strike price, regardless of the market’s current value.
Another hedging strategy is using call options as insurance against potential gains. By purchasing call options on an underlying asset they already own, investors can protect their potential returns in case the asset’s price increases unexpectedly. This strategy is known as covered call writing and can also generate additional income for investors through the premiums received from selling the call options.
Position sizing
Position sizing is a critical risk management strategy determining how much capital to allocate to each trade. In the context of listed options trading in Singapore, position sizing involves calculating the appropriate number of options contracts to buy or sell based on risk tolerance and market conditions.
A standard method for position sizing is using a fixed-percentage model. Under this approach, investors allocate a predetermined percentage of their capital to each trade. For instance, if an investor uses 5% as their fixed percentage, they will invest 5% of their money in each trade, regardless of the risk involved.
Another approach is using the Kelly Criterion formula to determine position size. This formula considers an option’s probability of success and the potential reward-to-risk ratio to calculate the optimal position size for a particular trade.
Stop-loss orders
Stop-loss orders are a risk management strategy that involves setting a predetermined price at which investors will exit a trade to limit potential losses. In listed options trading, stop-loss orders can be used to protect against adverse market movements.
One common type of stop-loss order is the trailing stop. This order follows the market’s direction and adjusts the target price accordingly. For instance, if an investor sets a trailing stop at 10%, and the underlying asset’s price increases by 5%, the target price will increase by 5%.
Another type is the time-based stop-loss order, which automatically exits a trade after a specific timeframe has elapsed. This strategy can be helpful in case of unexpected market events or prolonged periods of low volatility.
Throttling
Throttling is a risk management strategy that reduces the position size as the market’s volatility increases. In listed options trading, this strategy can help investors minimise potential losses during periods of high market uncertainty.
For instance, if an investor usually trades ten contracts per trade and the market experiences high volatility, they can reduce their position size to five contracts. This way, investors can still participate in the market while reducing their risk exposure.
Throttling also involves adjusting the number of trades based on market conditions. For instance, if an investor executes ten trades daily but the market’s volatility increases significantly, they may only decide to execute five trades. This strategy can help investors avoid overtrading and maintain a balanced risk-reward ratio.