A Guide to Risk Management with Options Investing

Wall Street is always a bit of a roller coaster, but in early 2022, it seemed like everyone was in for a long, downhill ride. At the beginning of June, the Federal Reserve Bank issued new data revealing that the net worth of individuals and nonprofit organizations decreased by anywhere from $500 billion to $149.3 trillion.

The biggest conception about the stock market is that when numbers are down, it’s time to get out by cutting your losses. Others see this as an opportunity. In fact, strategic investing in a bear market can yield significant long-term results. There’s a reason the adage “buy low, sell high” has persisted over the years.

A key component of investing wisely is prioritizing risk management. In spite of its undeniable importance to successful investing, most available resources spend little time on risk management. When they do, their guidance is often overgeneralized and hastily addressed. There's a reason for that: risk management is not an easy concept to define.

In this blog post, we’re going to dive into risk management guidelines and discuss how you can use stock options to minimize your investment risk to achieve your long-term goals.

Risk Management Begins with Financial Literacy

Even though states across the country are proposing bills that make financial literacy a requirement for high school students, there’s currently several adult generations that were not taught these crucial life skills. Managing your personal finances ensures you can achieve goals such as home ownership, wealth accumulation, and retirement as well as experience a daily sense of security knowing you have what you need to cover your expenses.

Personal finance encompasses more than paying your bills and building an emergency fund. It’s also about accruing wealth and limiting risk in the process. But all of these tasks, from covering your expenses to establishing a diversified portfolio, are dependent on your financial literacy.

Without the education that future students will receive in high schools across the nation, many adults right now find themselves in precarious financial situations.

• 35 percent of adults could not cover an unexpected $400 expense with cash or an equivalent, many saying they would put it on a credit card and carry a balance (rather than pay it off right away), and 12% said they would have no means to pay the expense at all.
• Two-thirds of American families lack an emergency fund (equivalent to six weeks of after-tax pay).
• 61 percent of American adults currently live paycheck to paycheck.
• 55 percent of adults expect to keep working after retirement.
• 37 percent of those with student loan debt are unable to make their monthly payments.

Those are some very scary statistics. Without the knowledge or tools necessary, the people in these challenging circumstances are unable to find a solution to take control of their finances. Fortunately, all of this information is available from the convenience of your home or mobile device. Budgeting apps, expert insight, and investment educational courses (such as 14-Day Option Investor) can help enterprising adults develop financial literacy on a whole new level.

As you begin to improve your financial literacy, you’ll come across the phrase risk management. This is a vital concept to master because unacknowledged risk exposure is a top reason people find themselves in bad financial situations.

Understanding Risk Management

Risk management is a broad term applied to several fields including personal finance but a quick Google search for the phrase yields results that don’t relate to personal finance at all.

So, yeah, Google is of no use in this scenario. You’re also going to feel even more confused after you’ve read the definition on Investopedia.

You can see how tricky it is to define risk management. Even financial professionals struggle to explain it in a way that’s easy to grasp. At Record Options Investing (ROI), we define risk management as a multi-pronged strategy to protect and grow your wealth. There’s no single tool, method, or resource for managing risk. That’s why financial literacy and risk management are two peas in a pod.

Why is Risk Management Important?

Do you like losing money? You’re not alone. Nobody does, regardless of their income or accumulated wealth. That alone is reason enough to prioritize risk in all of your investments.

If you’re going to invest in anything, it’s crucial that you know the extent of your risk. Blindly entering into an investment without definitively knowing the total amount of risk you would experience in the worst-case scenario is foolhardy. Can you lose all of your money or could you lose more than what you initially invested? Under what conditions will you lose your investment? These are vital questions to have answers for before you hand over a single cent.

Two primary reasons people forgo managing their investments is their fear of risk and lack of financial literacy. The idea of losing any part of your invested sum (let alone all of it) is, at the very least, unsettling. That’s why people entrust their hard-earned assets to financial planners and money managers. They believe their money will be safe and steadily grow under the watchful eye of a financial professional. Yet these professionals consistently underperform the S&P 500. Translation: these “safe bet” financial experts actually end up losing their clients’ money. So there’s actually significant risk in paying a financial planner to manage your investments. And don’t forget you’re paying this person for the privilege of them losing your money.

It makes sense that 90 percent of survey respondents in March 2022 reported experiencing stress due to money. That same survey revealed that 40 percent hadn’t taken any measures to secure their financial future. While money doesn’t buy happiness, it does provide stability and security, ensuring you have basic needs such as food and shelter. Money also makes it possible to achieve important milestones throughout life like higher education, home ownership, paying off debt, and retirement. It’s easy to see why so many people experience stress related to their finances.

The biggest misconception about finance is that investing is only for the rich. But the truth is the rich (or their grandparents) achieved their monetary multitudes through investing. The 99 percent of us that aren’t wealthy think that investing is only for those with billions in the bank because those are the people with money to lose.

But as President John F. Kennedy said, “There are risks and costs to action. But they are far less than the long range risks of comfortable inaction.”

You can’t afford to continue hoping your 9-5 job will provide you with the means to cover the costs of living comfortably. Investment and risk are inextricably linked; nothing in life is certain. However, by taking the time to learn how to invest in the stock market, even those stressed about their finances with a low tolerance for risk can still invest successfully. The key is comprehensive financial literacy (and maybe just a little confidence).

The trick is that investing doesn’t necessarily mean exposing yourself to incredible loss. When you’re financially literate and armed with some simple investing strategies, you can exercise great control over your financial future.

We advise any person to be 100% clear on the financial downside of any investment. Anything less than that is poor risk management and could jeopardize everything from retirement plans to banking accounts and credit scores.

Improving Your Financial Literacy Online

As Jim Lebenthal, CNBC contributor and chief equity strategist at financial advisory firm Cerity Partners, recently explained, “Financial literacy, to me, means that an investor understands not just the potential returns from an investment but the risks. When I say ‘investment’ it can be more than a stock or a bond. It can be an entire investment plan and an asset allocation. But it’s very important that an investor, through financial literacy, understands the returns and risks that are inherent in any investment.”

The importance of financial literacy and thorough research before investing cannot be overstated. But for those of us still paying off student loans and working full-time jobs, going back to school to learn economics and finance isn’t an option. Fortunately, there’s a magical place called the information superhighway, where you can learn everything you need to know about investing. And soap making. And cookie baking. And picture taking.

The internet is an invaluable tool for any person wanting to improve their financial literacy and democratize Wall Street. Endless resources are available to the inquisitive, but that’s also a double-edged sword. For those pursuing increased financial literacy, it’s challenging to discern trustworthy information from questionable content.

This is especially true on social media site Reddit. We’ve previously discussed the Reddit forum (called a subreddit) Wall Street Bets and the people who use it as a means for learning about options trading. Users also flock to the Personal Finance subreddit for guidance. This has many wondering if they can rely on r/PersonalFinance for investment advice.

The Personal Finance subreddit is an open community for users to “Learn about budgeting, saving, getting out of debt, credit, investing, and retirement planning.” Here you can read through people’s questions about a myriad of money-related topics. You may even stumble upon a few posts that relate to your particular situation.

And sure, a portion of the responses to posts on r/PersonalFinance come from people with various professional and expert backgrounds. In that context, it can be easy to forget that literally anyone can comment on these threads. You could unknowingly take advice from someone with no real world experience who finds themselves in a worse financial situation than yours. Just because someone speaks with confidence doesn’t mean they’re correct.

That’s not to say that every person commenting on r/PersonalFinance posts is wrong. At ROI, we think Reddit is a great jumping off point for building a solid understanding of finance. But it’s vital to keep in mind that the information you glean from your hours of Reddit scrolling does not constitute the end-all, be-all in financial education. There’s valuable tips to be found on r/PersonalFinance and other subreddits, but you should always do additional research to confirm that the information you get is accurate before you act on it.

As classical English author and well-known satirist Jonathan Swift said, “A wise person should have money in their head, but not in their heart.” While reading through comments on Reddit is a great start, your future requires thorough financial literacy built on knowledge from multiple, reliable resources. Bottom line: You won’t achieve financial stability and beyond by solely relying on the advice of Reddit users or any other single source.

Encountering Risk in Personal Finance

Earlier in this post, we defined risk management in personal finance as the methodology used to keep and increase wealth. Without evening realizing it, you’re already implementing risk management measures to protect yourself from liability. For example, your auto insurance premium limits your financial responsibility in the event of a collision. Rental insurance covers you in the event of theft. Life insurance provides finances for loved ones in the event of catastrophe.

In personal finance, you may encounter any number of risks:

1. Income risks including unemployment, disability, and death.
2. Emergency risks that you don’t have the money or credit to cover.
3. Debt risk occurs with a bad credit score, taking on too much debt, or accruing bad debt (loans with high interest rates and finance charges).
4. Investment risks vary depending on the type of investment. For instance, vandalism, theft, or destruction are some of the risks associated with investing in real estate.

There’s numerous methods for managing personal finance risks, and you can (and should) familiarize yourself with them so you’re ready in case the unexpected happens. However, risk is never 100% avoidable regardless of how much you prepare, which is vital to remember when you invest in anything, whether it’s classic albums, audio equipment, or option contracts.

Investing and Risk Management

With any investment, there’s two primary components: risk and reward. All too often, people find themselves zeroed-in on the reward of an investment without contrasting it against the risk. These investors don’t realize that with investing, high reward almost always equals high risk.

Entering into any investment without understanding the full extent of your downside is dangerous. Depending on the type of investment, you could lose more than you initially put into the scheme. Financial literacy and risk management go hand-in-hand because you can only limit exposure with the knowledge to do so.

Ultimately, no matter what the investment is, you need to regularly reassess your position to properly manage your risk. Many bailed on Wall Street at the beginning of this year because of the market’s downturn without fully examining their investments to determine if it was the right time to implement their exit strategies. Reevaluating investments to manage risk includes answering these questions:

• Why did you invest in each position?
• At what price did you enter the position?
• What’s your confidence in the company?
• Have you set a stop loss limit?

No Investment is Risk-Free

As you explore investment vehicles that limit your risk while generating returns, you’ll read and hear about all sorts of opportunities that promise incredible results. But investing is inherently risky and there’s no investment technique that is without risk. Still people will tell you all about their risk-free way of accruing wealth.

For example, there’s a sector of investors that believe United States Treasury bonds are the lowest risk method for building wealth. As prices on Wall Street took a nosedive, the bond market has seen astronomical activity. The Treasury Department reported $3.4 billion in sales of US Series I bonds for June, an increase of 950% compared to the same month last year.

While the Federal Reserve increased interest rates for a third time this year in June, many investors don’t realize the interest risk involved with bonds. Fluctuating interest rates affect the value of bonds. It might seem like good news that the Fed keeps bumping up those rates but those increases ultimately decrease the value of previously issued bonds.

Let’s look at how interest risk plays out for a bond investor. An investor buys a $10,000 10-year US Series I bond when the interest rate is 1.8 percent. A few years later, that person needs to cash out the bond. At the time they want to cash in the bond, the rate has increased to 2.4 percent. That means, the discounted price of the bond to achieve parity is only $7,500. Since you’re unable to control the timeframe of your bond investment, you are beholden to the decisions of the Federal Reserve.

Managing Risk with Options Investing

Unlike bonds, options investors have full control over the timeframe of their investments. We’re not saying that options trading is risk-free. That’s absolutely not true. As we’ve previously stated, there’s no way to avoid risk when you’re investing. However, savvy options investors that utilize time-tested strategies can manage their risk and generate consistent returns.

That’s why our revolutionary education platform covers risk management as it pertains to investing with options trading. We teach users that you should never enter into any options trade without a complete understanding of your risk.

For investors considering risk management through options trading, Record Options Investing's 14-Day Option Investor provides retail investors with a comprehensive education course that explains how to manage risk through options trading. 

Bestselling author of The Psychology of Winning Denis Waitley said, “Life is inherently risky. There is only one big risk you should avoid at all costs, and that is the risk of doing nothing.”

Can you afford not to invest your money for the future? Probably not. There’s no better time than this very moment to increase your financial literacy and learn how to manage risk with investing in options trading. Sign up today!