Risk mitigation is crucial to any investment strategy, especially regarding trading options on the SGX in Singapore. Options are complex financial instruments that allow traders to wager on the future price movements of an underlying asset. However, they also present significant risks due to their inherent complexity and leverage.
As such, traders must have adequate risk mitigation methods, especially when dealing with barrier options. Barrier options are contracts with predetermined levels that trigger or extinguish their existence once breached. They provide traders with more flexibility than traditional options but also come with additional risks. This article will discuss advanced risk mitigation methods for barrier options on the SGX.
Use limit orders for barrier levels
One of the most common ways to mitigate risk when trading barrier options on the SGX is using limit orders for barrier levels. A limit order is an instruction given to a broker to buy or sell an asset at a specific price. Regarding barrier options, traders can use limit orders to set their desired barrier level, which will trigger once it reaches that particular price. By doing so, traders can control their exposure and limit potential losses if the barrier level is breached.
The advantage of using limit orders for barrier levels is that it allows traders to set a predetermined risk level before entering a trade, giving them more control over their positions. Since barrier options have defined barriers that determine their existence, limit orders can help avoid unwanted trigger events, such as a market spike or flash crash. However, traders must account for potential slippage between the limit order price and the actual execution price, affecting their risk management strategy.
Hedging with other instruments
Another advanced risk mitigation method for trading barrier options on the SGX is hedging with other instruments. Hedging involves taking a position in one tool to offset the risks of another. Regarding barrier options, traders can use other derivatives, such as futures or options on futures, to hedge against potential losses.
Hedging with other instruments is an effective risk mitigation method because it allows traders to protect their positions from adverse market movements. For instance, if a trader holds a long barrier call option and wants to mitigate the risk of the underlying asset’s price falling, they can hedge by buying a put option on the same asset. In doing so, gains from the put option will offset any losses from the barrier option.
However, hedging with other instruments comes with its own set of risks. For example, the cost of hedging can affect the overall profitability of a trade. If the hedge does not perform as anticipated, traders may have a net loss on their positions.
Use reduced barrier levels
Another advanced risk mitigation method for trading barrier options on the SGX is reducing barrier levels. This method sets the barrier levels lower than the option’s current strike price. By doing so, traders can reduce their potential losses if the barrier is breached.
Reducing barrier levels is an effective risk mitigation method because it limits traders’ downside risk while maintaining exposure to potential returns. However, this also means that traders may have to pay a higher premium for the option due to the reduced barrier level. If the barrier is breached, traders may miss out on potential returns from a more significant price movement.
Adjusting position sizes
Traders can also mitigate risk by adjusting their position sizes when trading barrier options on the SGX. Position sizing determines how much capital to allocate to each trade based on risk tolerance, portfolio size, and other factors. By adjusting position sizes, traders can limit their exposure to any single trade and diversify their risk.
This method is effective because it allows traders to control the amount of capital at risk in a particular trade. It also enables them to spread their risks across multiple trades, reducing the impact of any potential losses. However, traders must balance position size and potential returns, as more minor positions may yield lower returns.
It is crucial to note that adjusting position sizes alone may not be sufficient for risk mitigation, especially when trading options with high leverage such as barrier options. Traders must also consider other factors like volatility and market trends.
Using trailing stops
Traders can also use trailing stops to mitigate risk when trading barrier options on the SGX. A trailing stop is an order that adjusts automatically as the price of an asset moves in a trader’s favour. Regarding barrier options, traders can set up trailing stops to limit potential losses if the barrier is breached.
The advantage of trailing stops is that it allows traders to lock in trades while limiting potential losses. Since the stop level adjusts automatically, traders do not have to monitor their positions constantly. However, traders must be careful when setting the trailing stop level to avoid being stopped out too early due to market volatility.