Mental Capital: Risk Management With Options

A research-backed playbook for reducing drawdowns without destroying long-term returns

Most traders talk about risk management the way people talk about diets.

They want a system that keeps all the upside, removes all the downside, and doesn’t require any uncomfortable tradeoffs. In markets, that fantasy doesn’t last long. The market has a way of charging you for whatever you demand.

Academic work on options pricing has been remarkably consistent on one point: you can reshape risk with options, but you can’t erase it. You’re always paying in one of three currencies:

• Carry cost (your hedge bleeds over time)

• Capped upside (you give up some participation)

• Tail exposure (you collect premium most weeks… and then the bill arrives in a cluster)

The best risk management approach isn’t a clever trade. It’s a repeatable policy, something you can run when markets are calm and when they’re ugly, without reinventing yourself every time volatility wakes up.

This is the framework I trust, teach, and use.

The three truths you need to accept before options can protect you

1) Protection works, and it’s priced like it works

If you want crash insurance, you can buy it. It will reduce drawdowns. It can save you during fast selloffs.

It also tends to be expensive over long stretches because the market consistently prices protection above the “average outcome.” That’s not a conspiracy. It’s a feature: the world wants insurance most when it’s needed most.

So if you buy hedges expecting them to be “good trades,” you’ll abandon them the moment they behave like insurance.

2) Volatility spikes are where portfolios break

The damage in markets isn’t usually death by a thousand paper cuts. It’s the moments when price drops fast, volatility expands, correlations jump, and liquidity gets worse right when you want it.

Those are the periods when short-vol and premium-selling portfolios feel like they’re moving in slow motion while the market moves in fast forward.

3) Premium selling gets paid for warehousing stress risk

Selling options has a long history of working because people overpay for protection. That’s the business model.

But the cost of that edge is structural: losses cluster. You can go months collecting steady premium and then take a hit in a few sessions that feels wildly disproportionate.

That isn’t a failure of probability. It’s how risk expresses itself.

Once you accept these truths, you stop asking options to perform magic, and you start using them like a professional: to define outcomes, control exposure, and stay in the game.

The best approach: a rules-based risk overlay

Here’s the mistake I see over and over: traders hedge positions instead of hedging the portfolio.

They’ll stare at one trade, feel nervous, and buy protection in that name, often at the worst time, in the least liquid chain, with the widest spreads. Then they’ll stop hedging when things calm down because the cost “wasn’t worth it.”

That is not a policy. That’s mood management.

A portfolio overlay is different. It’s intentionally boring. It does three things:

1. It defines your pain threshold.

2. It sits in liquid products where spreads behave.

3. It runs on schedule so you don’t hedge late.

If you want risk management to work, it needs to survive your own psychology.

Step 1: Define risk in a sentence you can’t wiggle out of

Most people say, “I want less risk,” and what they mean is, “I want less discomfort.”

So be specific:

That sentence changes everything.

If you can tolerate a 10 to 15% drawdown, you hedge differently than someone who can’t tolerate more than 5 to 8%. If you need to protect over a quarter, you hedge differently than if your horizon is a year.

Your hedges fail when your risk definition is vague. Options require precision.

Step 2: Hedge the portfolio, not your anxiety

For most traders running diversified options strategies, index-level structures are the cleanest place to hedge. They’re more liquid, spreads are tighter, and you aren’t fighting single-name landmines like earnings gaps and idiosyncratic news.

You can trade Wheel positions, PMCCs, spreads, condors, whatever your core engine is, but your hedge should be simple and consistent. Complexity belongs in the return engine, not in the seatbelt.

Step 3: Choose an overlay you can actually keep on

Here’s the practical menu. I like to split it into two buckets:

• Price hedges (they pay when the market drops)

• Volatility hedges (they pay when volatility spikes, even if price is messy)

A) Put spreads (price hedge, my default for income portfolios)

A put spread is straightforward:

• Buy a put in the zone where the portfolio starts to feel real pain

• Sell a lower put further out to reduce cost and define the hedge

This is the cleanest compromise I’ve found between protection and sustainability.

Naked puts can be effective, but they often cost enough that people eventually turn them off, especially after a long bull run when “nothing bad happens.” A spread lowers that cost, which increases the odds you stick with it.

Put spreads function like a shock absorber:

• In normal markets, you pay a small ongoing “premium” for protection

• In fast selloffs, the hedge can expand rapidly and offset stress losses from short puts, bull put spreads, and the downside of iron condors

B) Collars (price hedge funded by upside)

A collar is:

• Long stock or index exposure

• Long put protection

• Short call to help finance the hedge

Collars are honest. You’re saying, “I’d rather give up some upside than live through large drawdowns.”

They work best when you’re meaningfully long delta, stock-heavy portfolios, PMCC-heavy portfolios, where the goal is smoother equity-like exposure with guardrails.

But collars come with a psychological cost: capped upside. If you know you’ll resent that in a bull market, you won’t keep it on. And an overlay you can’t keep on isn’t protection, it’s a temporary coping mechanism.

C) Credit spreads as hedges (defined-risk “portfolio brakes”)

This is where most traders get tripped up, so let’s be precise.

A credit spread can be an income trade…or it can be a hedge. The difference is intent and sizing.

The hedge version is typically a bear call spread on an index, small, defined risk, designed to add negative delta and pay in a pullback or sideways market.

Why this belongs in a risk overlay toolkit:

• It’s defined risk (no unlimited exposure)

• It can be cheap-to-carry relative to pure long puts

• It’s excellent for “grind-down” markets where volatility doesn’t explode immediately, but the tape stays heavy and rallies fail

The tradeoff: credit spreads are not crash insurance. In a waterfall selloff, they help, but they won’t behave like convex tail protection the way put spreads or VIX calls can.

Think of bear call spreads as brakes, not airbags.

Used correctly:

• small size

• placed far enough away that you’re not hedging by standing directly in front of a train

• managed with rules so it doesn’t become a stubborn position you “hope” comes back

D) “Buying the VIX” (volatility hedge, your airbags)

If price hedges are seatbelts, volatility hedges are airbags: they’re designed to help when the move is violent.

When traders say “buy the VIX,” what they usually mean is buying exposure to volatility spikes, often via VIX calls (or structures tied to volatility).

Why it can be powerful:

• Volatility can rise faster than price can fall

• In fast risk-off moves, a small volatility hedge can expand dramatically

Why people mess it up:

• Volatility is mean-reverting

• Carry can be harsh if you use the wrong vehicle

• “Holding it forever” without rules turns it into a slow leak

The cleanest mindset for a VIX hedge:

• small allocation

• planned duration (you’re buying protection for a window, not a lifestyle)

• clear profit rules (vol spikes are often quick, treat them like events)

In practice, volatility hedges work best as a complement, not a replacement, for price hedges. A small VIX call position paired with a put-spread overlay can cover different failure modes: the sudden spike and the grinding decline.

Step 4: Run it like a policy with a hedge budget

The worst hedging habit is reactive hedging:

• buying protection after volatility expands

• stopping protection after volatility falls

That’s paying top dollar for insurance and canceling it the moment it becomes affordable.

Instead, set a hedge budget you can sustain and implement mechanically on a schedule, monthly or quarterly.

The right hedge isn’t the most precise hedge. It’s the hedge you can run continuously without second-guessing every day.

How I apply this as a premium seller

If you sell premium, Wheel puts, credit spreads, iron condors, you are exposed to a specific enemy:

fast downside + volatility expansion.

Your hedge doesn’t need to be large. It needs to be consistent and convex enough to matter when the tape gets ugly.

Here’s the division of labor:

• Premium selling is your carry engine (steady income over time)

• The hedge is your survival engine (keep drawdowns from forcing bad decisions)

A simple template that fits most income portfolios:

• Keep your core strategies as-is

• Add a small index-level put spread overlay on a schedule

• Use bear call spreads as tactical brakes when the market is stretched and you want defined-risk negative delta

• Consider a small volatility hedge for periods when you want protection against a fast shock

Strike selection without turning it into a guessing game

Don’t pick strikes based on vibes. Pick them based on “room to be wrong.”

• Put-spread longs sit near the zone where you’d start making emotional decisions if the market fell quickly

• Bear call spreads sit far enough away that you aren’t hedging by picking a top

• Volatility hedges are sized so you can hold them without obsessing, and managed with profit rules when they expand

The rule that keeps this from becoming chaos

Your overlay should reduce drawdowns without hijacking your week.

That means:

• one schedule

• one sizing logic

• one management rule-set

• minimal improvisation

The biggest mistake: judging protection by P&L

A hedge is not “working” only when it makes money.

A hedge is working when it keeps you from doing something catastrophic, over-rolling, over-sizing, forced liquidation, capitulation at the lows.

It’s a seatbelt. You don’t wear it because you expect a payout. You wear it because the alternative is unacceptable.

Closing thought: survive first, optimize second

Options don’t remove risk. They relocate it.

• Buying protection relocates risk into carry cost

• Selling premium relocates risk into tail exposure

• Put spreads, collars, credit-spread brakes, and volatility hedges relocate risk into designed compromises

The best way to manage risk with options is the approach you can run continuously through different regimes, calm tape, choppy tape, and panic tape, without changing who you are.

Because the real edge isn’t the clever trade.

The real edge is staying solvent, staying rational, and staying in the game long enough for your process to compound.

Probabilities over predictions,

Andy Crowder

If this Mental Capital series helps you think more clearly about trading, do me a favor: share it with one trader friend (or post it in your favorite community). I’m growing The Option Premium the old-fashioned way, word of mouth, and I genuinely appreciate every reader who helps spread it.

At The Option Premium, we build systematic strategies around capital preservation as a primary principle. In our publications Wealth Without Shares, The Income Foundation, and The Implied Perspective, every position is designed with defined risk and capital efficiency. We're not trying to hit home runs, we're trying to compound capital reliably over decades. If that approach resonates with you, explore our services to see how systematic options trading can work for you.

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Disclaimer: This is educational content only. Not investment advice. Options involve risk and aren't suitable for all investors. Examples are illustrative. Real results will vary. Talk to professionals before you risk real money.