Risk Management for the Small Trader

I treasure each comment and often enter into a dialog. This time I disagree with a substantial portion of Steve B’s reply. This post is offered to provide food for thought for the rookie traders who visit these pages.

Steve offered the following comment in response to a post in which I used a fictional trade to illustrate a point.

The fictional trade

• Open a new iron condor position in an index
• The call spread and put spread are each 20-points wide
• Collect premium: $400
• Maximum risk: $1,600
• Margin requirement: $1,600 (although some brokers require $2,000 or $4,000)

Steve’s comment

For a trader (experienced or beginner), wouldn’t the ratio and risk acceptance depend heavily on account size? If a new trader starts out with a $5k trading account, which is a pretty decent sized starting account, he can’t be wrong too many times risking $800/trade. That is a pretty heavy % of his overall account to be risking on 1 trade, in my opinion. I don’t think that you are advocating new traders risking 15-20% of their account on each trade. That is trade suicide. 🙂

On top of that, if the true max risk of the trade is $1,600, keeping with the example, wouldn’t that also greatly affect his buying power and ability to have more than 1 trade at a time?

I totally understand where you are coming from especially as a seller of options and agree. But tying back to your previous blog on the trader who ignores all advice on risk… I would hate for a new trader with a $3-$5k starting account blow up his account in 3-5 trades because he was willing to accept $800 loss each time. So I was trying to keep the examples low [MDW: He suggested taking profits when they reach $300 and cutting losses if they were as high as $150] in case someone just used a given number as hard fact and went out to apply it.

I’ve modified my initial response

Steve B,

I agree that the amount the trader can afford to place at risk depends on account size. No one would disagree. However, the point that you miss is that this trade is completely inappropriate for someone with such a small account.

It may be none of my business, but I don’t like to see people trading options when under-funded. You describe $5,000 as a ‘pretty decent sized trading account.’ In my opinion, that’s not nearly enough. I recommend a minimum of $10,000 – and prefer double that amount.

Options are not stocks and cannot be traded the same. It’s one thing to make a small investment and set a stop-loss (which does it’s job most of the time). It’s another to trade options. Small account holders understand limited risk, and as a result tend to be option buyers. That’s right. I believe that brokers who allow traders to open an account with only $2,000 to $3,000 encourage them to lose money. Not deliberately. However, those small accounts encourage the newbie to begin trading by buying options. Not only do rookies have no idea how much to pay for an option or what implied volatility is or can do to the option price, but trying to make money when buying options is an extremely difficult task – at best. I honestly describe it as impossible for the vast majority.

Bottom line: Small account holders adopt losing strategies – because they don’t have enough capital to make better trades.

And if someone did have that $5,000 account,why in the world would he/she want to trade a 20-point iron condor? One of the best methods for managing risk is to avoid initiating trades that are inappropriate for the trader and his/her account.

There’s one more point. Given the choice between managing this iron condor with a maximum loss of $150 or $800, I’ll take the $800 any time.

The person who sets a $150 mental stop loss will take that loss far more than half the time, making the iron condor strategy a losing proposition. I’ll wager that you neglected to consider that this is a 20-point spread and that $150 is not a very large loss over a period of a few days. Perhaps you had your thoughts set on a 10-point iron condor, where a $150 maximum loss is much more reasonable (still too low for my style, but it’s reasonable).

I believe you are misguided when you suggest that ANYONE would take a dollar amount as a ‘hard number’ and establish that as the maximum loss for any trade. That would be far more than absurd.

As you know, I NEVER recommend a trade. That violates one of my core beliefs:

When someone sells a trade recommendation, the advice seller probably believes the trade will be profitable. However, ultimate profitability is not only dependent on the trade chose, but also depends on how it is managed. That salesman may be able to turn a profit, but that does not mean that you would. Your pain threshold is lower and there would be many instances in which you exit with a loss and he holds and earns a profit.

He claims a profit for his followers and all you see is a loss. Do you understand why that happens?

Each trader has his/her own comfort zone, trading goals and the ability to withstand a loss. Each would exit the trade at a different time. Each is at a specific point in life – perhaps raising a young family or retired. Perhaps wealthy or struggling. No one who understands trading would suggest the same trade to every person. Yet, that’s what these gurus do.

I NEVER recommend any trades for the reasons cited. I would have to know more than I could possibly know about the person to whom the recommendation is being made. Similarly, I never suggest a risk limit for anyone else.

Ok, that’s my rant for today.

The Rookie’s Guide to Options