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What is Limited Risk?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 30 June 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Limited risk is the amount of risk associated with an investment that has a predetermined limit on just how much the investor can lose while in possession of the security. Some risk provisions of this type are found with options contracts, as well as some futures contracts. By identifying a maximum loss, it is often possible to secure investors who would not be interested if the degree of risk was unlimited.

In many cases, the limited risk is capped at the amount of the premium that the investor paid to acquire the option. This creates a situation where even if the underlying securities do not perform as anticipated, the investor can only lose the sum total of that initial investment. Should the underlying securities remain more or less flat for as long as the investor chooses to own the option, there is neither a gain nor a loss sustained. Thus, the investor is able to minimize the impact of the failed investment on his or her portfolio, and move on to other investment opportunities.

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The concept of a limited risk is often attractive to conservative investors. In contrast to investment options that carry uncapped or unlimited risk, the investor knows going in that there is only so much at stake. At the same time, there are no limits imposed on the increase of the value of the underlying securities, so the investor still retains full potential to earn a significant return. The only difference is that the investor is protected from losing any money on the deal if the securities fail for some reason.

Investors who prefer investments that come with the promise of a high return along with greater volatility may not consider an option carrying a limited risk to be worth the effort. While there is a guarantee of sustaining no more than a certain amount of loss, the underlying securities may not be capable of generating the degree of return that a risk-taker would consider a good acquisition. However, there are options structured with a limited risk that also carry a higher volatility, sometimes enough to attract more aggressive investors.

Identifying the presence of a limited risk provision is not difficult to manage. The terms and conditions surrounding the options trade will include detailed information on the presence of this type of protection for the investor. In addition, brokers often search for investments of this type when they know that a given client has an affinity for options that come with a limited degree of risk.

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