Tag Archives | risk management

The Art of Making Decisions when Trading

One of my basic tenets in teaching people how to trade options is that rules and guidelines should not be written in stone and that there are valid reasons for accepting or rejecting some of the ideas that I discuss.

When I offer a rationale or explanation or a suggest course of action, it is because I have found that this specific suggestion has worked best for me and my trading. I encourage all readers to adopt a different way of thinking when appropriate. The following message from a reader offers sound reasons for taking specif actions regarding the management of an iron condor position. My response explains why this specific reasoning is flawed (in my opinion).

The question

Hi Mark,

I have some questions on Chapter 3 (Rookie’s Guide to Options) Thought #3: “The Iron Condor is one position.”

You mentioned that the Iron Condor is one, and only one, position. The problem of thinking it as two credit spreads is that it often results in poor risk-management.

Using a similar example I (modified a little bit from the one in the book) traded one Iron Condor at $2.30 with 5 weeks to expiration:
– Sold one call spread at $1.20
– Sold one put spread at $1.10

Say, a few days later, the underlying index move higher, the Iron Condor position is at $2.50 (paper loss of $0.20):
– call spread at $2.00 (paper loss of $0.80)
– put spread at $0.50 (paper profit of $0.60)

I will lock in (i.e., buy to close) the put spread at $0.60 for the following reasons and conditions:
1. it is only a few days, the profit is more than 50% of the maximum possible profit
2. there are still 4 more weeks to expiration to gain the remaining less than 50% maximum possible profit. in fact, the remaining profit is less as I will always exit before expiration, typically at 80% of the maximum possible profit. so, there is only less than 30% of the maximum possible profit that I am risking for another 4 more weeks.
3. the hedging effect of put spread against the call spread is no longer as effective because the put spread is only at $0.50. as the underlying move higher, the call spread will gain value much faster than the put spread will loss value.

Is the above reasoning under those conditions ok? Will appreciate your view and sharing. Thank you.

My reply

Bottom line: The reasoning is OK. The principles that you follow for this example are sound.

However, the problem is that you are not seeing the bigger picture.

1. There is no paper loss on the call spread. Nor is there a paper profit on the put spread. There is only a 20-cent paper loss on the whole iron condor.

2. When trading any iron condor, the significant number is $2.30 – the entire premium collected. The price of the call and puts spreads are not relevant. In fact, these numbers should be ignored. It is not easy to convince traders of the validity of this statement, so let’s examine an example:

Assume that you enter a limit order to trade the iron condor at a cash credit of $2.30 or better. Next suppose that you cannot watch the markets for the next several hours. When you return home you note that your order was filled at $2.35 – five cents better than your limit (yes, this is possible). You also notice the following:

  • The market has declined by 1.5%.
  • Implied volatility has increased.
  • The iron condor is currently priced at $2.80.
  • Your order was filled: Call spread; $0.45; Put spread; Total credit is $2.35.

Obviously you are not happy with this situation because your iron condor is far from neutral and probably requires an adjustment. But that is beyond this today’s discussion — so let’s assume that you are not making any adjustments at the present time.

That leaves some questions

  • Do you manage this iron condor as one with a net credit of $2.35? [I hope so]
  • Do you prefer use to the trade-execution prices?

If you choose the “$2.35” iron condor, it is easy to understand that this is an out-of-balance position and may require an adjustment.

If you choose the “45-cent call spread and $1.90 put spread” then the market has not moved too far from your original trade prices, making it far less likely that any adjustment may be necessary.

In other words, it does not matter whether you collected $2.00, $1.50, $1.20, $1.00, or $0.80 for the put spread. All that matters is that you have an iron condor with a net credit of $2.35.

3. You should consider covering either the call spread, or the put spread, when the prices reaches a low level. You are correct in concluding that there is little hedge remaining when the price of one of the spreads is “low.” You are correct is deciding that it is not a good strategy to wait for a “long time” to collect the small remaining premium.

If you decide that $0.60 is the proper price at which to cover one of the short positions, then by all means, cover at that point. (I tend to wait for a lower price).

If you want to pay more to cover the “low-priced” portion of the iron condor when you get a chance to do so quickly, there is nothing wrong with that. However, do not assume that covering quickly is necessarily a good strategy because that leaves you with (in your example) a short call spread — and you no longer own an iron condor. If YOU are willing to do that by paying 60 cents, then so be it. It is always a sound decision to exit one part of the iron condor when you deem it to be a good risk-management decision. But, do not make this trade simply because it happened so quickly or that you expect the market to reverse direction. If you are suddenly bearish, there are much better plays for you to consider other than buying back the specific put spread that you sold earlier.

4. The differences in your alternatives are subtle and neither is “right’ nor ‘wrong.”

The main lesson here is developing the correct mindset because your way of thinking about each specific problem should be based on your collective experience as a trader.

Your actions above are reasonable. However, it is more effective for the market-neutral trader to own an iron condor than to be short a call or put spread.

You are doing the right thing by exiting one portion of the condor at some “low” price, and that price may differ from trade to trade. But deciding to cover when it reaches a specific percentage of the premium collected is not appropriate for managing iron condors.

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Adjustment Woes

Hi Mark have been trading iron condors for awhile but always get burnt when time comes to adjust

Hello Kaye,

Adjustments prevent getting burned. So let me make a few observations:

    –If you wait too long and have already lost too much money by the time that you decide to adjust the position, then all the adjustment can do is help you not lose too much additional money. It is unlikely to produce a happy overall outcome. I understand that we don’t like the idea of adjusting too early because the market may reverse direction. However, there is a good compromise that depends on your comfort zone. I hope that you can discover that compromise. Consider adjusting in stages.

    –If it is the adjustment trade itself that produces the poor results, then there are alternate adjustment strategies. Rolling is not the only choice. And if you do roll, I urge you not to increase position size by more than a modest amount. It is okay to roll from 10 spreads to 12, but increasing size to 20-lots is just asking for trouble because some trades get rolled multiple times and positions can become var too large.

    –It is easy to get burned when you sell extra put spreads (on a market rally) or sell extra call spreads (on a decline). It the scheme of things, it is very important to prevent risk from escalating. Translation: If you must sell new put spreads on a rally, please cover the already existing put spreads — just in case we see a market just like the past week. The rising market reversed direction suddenly and made a bit move lower. There is not enough residual profit potential in that original put spread to risk leaving it uncovered. That is the reason it pays to cover when selling a newer spread.

    –If you are trading with a market-neutral bias, then the adjustment should return your position nearer to delta neutral than it was before the adjustment. In other words, when you do not have a market bias, try to avoid using the adjustment to recover lost money. Don’t suddenly decide to trade an iron condor that tries to take advantage of the current market trend. In general, iron condors are not suitable for traders with a market bias (unless it is a small bias).

    –If none of those situations apply, if you provide an example or two that describes what went wrong, I will try to provide some insight on your trade. Remember that every losing trade does not mean that the trader made any mistakes.

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Introduction to the Greeks

The Greeks are easy-to-understand (honest) tools for measuring risk. You, the trader can delve into the math or you can accept the numbers generated by your broker’s (or use another source) software.

The basis of risk management is using the numbers to control the possible gains and losses from your options trading.

At my about.com site I just published a string of articles for newer option traders:

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Managing Iron Condors: The Worst Adjustment

My oft-stated belief is that it is almost impossible to become a successful options trader without becoming a skilled risk manager.

When it comes time to decide how to reduce the risk of holding a position, there are many choices. The alternatives are too numerous to describe, however, the basic choices are

  • Do nothing. This is not risk management. This is wishful thinking
  • Adjust the trade to reduce risk
  • Cut position size by exiting all or part of the position

The best decision

making a decision

I believe that adjusting the trade represents the best choice, with the following stipulation: Once the position has been adjusted, the trader likes what he/she owns; believes it is likely to earn profits going forward; is no longer too risky to own, and satisfies the psychological needs of the trader. That last phrase simply means that it is comfortable to own the position and is not being held for the sole purpose of recovering a loss.

When it comes to adjusting, there are always going to be alternative trades from which to choose. Today I want to discuss one specific type of trade. I know that many traders like to adopt the example that I’ve chosen to highlight Despite that fact, I believe it is the worst possible choice.

The worst choice

    Assumptions: We opened an iron condor position and the market has declined to a point where the put spread has become worrisome. For this discussion, it doesn’t matter whether the put spread is 5% OTM (far too early to be concerned in my opinion); 3% OTM or ATM. The point is that the underlying asset has moved to a point at which the specific trader who made the trade is uncomfortable holding the position as is, and wants to make an adjustment.

    Let’s assume that the position is long 300 delta.

There is one adjustment method that I avoid discussing – just to minimize the possibility that it would occur to any reader to experiment with this trade idea. Keep in mind that the ONLY reason for making an adjustment is to reduce risk – as long as the new position is worth holding. We do not reduce risk to crate a position that we do not WANT to own.

So what is this adjustment that I think is so terrible?

It’s the sale of call spreads to add some negative delta to the portfolio. (Or put spreads when the market has been rising and the portfolio is delta short.) Selling call spreads accomplishes some noble goals: It move the position nearer to delta neutral. When trading with no market bias, that’s a good thing. It also adds more cash to the trader’s account, increasing the potential profit, and we all like to earn more money.

One other benefit of adopting this strategy is that it seems to work so often. Much of the time the market continues to drift lower, making this adjustment profitable. Of course the put situation has gotten worse. That’s not a real problem when the trader is on top of the situation and is taking steps to manage risk. However, all too often the steps taken include the sale of even more call spreads. Once again, taking in cash and reducing the immediate delta risk.

I must admit that this strategy works very nicely when it works. Sometimes the cash from the call sales is sufficient to cover all losses from the put side of the iron condor and the trader may eventually earn a profit. Sometimes the market stops moving lower and the trader not only earns the original cash collected when initiating the iron condor trade, but is rewarded with extra profits derived from the call sale.

That’s the good news.

However, the primary (if not the only) purpose of making the adjustment is to reduce risk. This method does reduce delta risk (temporarily), but it adds negative gamma and a significant downside risk. when selling those additional call spreads, too often the trader sells a cheap spread (so it is reasonably far OTM). That does notr add very much cash to the kitty, and adds major risk of loss – if the market turns – for very little cash. If the trader makes the better (but still terrible) choice of selling calls spreads that generate a ‘decent’ amount of cash, then there is at last a reward worth earning for taking the risk.

But that’s the point. Adjustments are risk-reducing trades (or should be). The idea that lessening delta risk makes for a good adjustment is not the way a successful or experienced executes adjustments. I understand how powerfully profitable this plan looks. But it only takes one large and sudden market reversal to blow up an account with far too much loss exposure.

But there are two potential disasters that await. I believe that the sole purpose of adjusting a position is to reduce risk – not to seek extra profits. [I am not against earning extra profits, but the primary purpose is to make the current position safer and worthwhile to hold.]
When extra call spreads are sold,nothing is done to reduce the risk presented by those put spreads.

Problem number One: If the market continues lower, the loss form the puts is going to increase rapidly. The sale of call spreads is not going to generate enough cash to offset these losses. Thus, the primary purpose of making an adjustment – to keep risk of loss at a reasonable level. Once those puts move into the money, it becomes far more difficult to manage the entire position. Not only are the put spreads problematic, but the continuing sale of call spreads can result in blowing up the trading account if there is a sudden market reversal.

Problem number Two: When keeping risk in line is not the MAJOR (it should be the only) consideration when making an adjustment, far too often risk builds and goes unnoticed. The type of trader who employes this ‘sell more calls’ method of risk management seldom bothers to buy back those now, far OTM call spreads. It’s bad enough to create downside risk – where none existed before – but to not buy back the cheap options creates a scenario in which a traders account can disappear overnight.

This is unacceptable risk (Obviously an pinion and not a statement of fact). But it is a tempting methodology. It works most of the time. It can lead to extra profits. It’s easy to fall in love with this strategy. But good luck does not hood forever. Markets do get volatile again, and despite promises that the trader makes to him/herself to act in plenty of time – f necessary – the personality that sells those extra spreads to bring in more cash – is not the right personality type to be able to rush in to cover those call spreads when the market turns. In fact he sale of additional put spread would probably be the trade of choice.

This is a disaster waiting to happen. I feel it is the worst possible adjustment chocei and would go as far as to say that if you are considering this play – selling more calls without buying back the original call position – it’s better to exit and take the loss, rather than to build risk to unacceptable levels.

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Trading Iron Condors in 2011

It’s 4½ months into the year and I’ve found this to be one of the easy periods for iron condor traders. Of course, that’s a personal opinion, based on my results. Here’s someone who seems to disagree, yet has made decent money with this strategy.

Christopher Smith at TheOptionClub.com

This year I committed to an experiment that has me trading an iron condor on the SPX every month – regardless of market conditions. The purpose of this exercise is to demonstrate techniques for managing risk and prove that with diligent risk management it is quite possible to limit losses while still creating profitable opportunities.

This year has not been particularly favorable for iron condors, but we have managed to avoid any significant loss and currently we have what amounts to a 20% yield on capital of $5,000 while risking approximately $4,000 or 80% of the capital – holding $1,000 or 20% in reserve.

One of us is living on a different planet. If not, then this comment illustrates that trade selection and risk management techniques vary tremendously among traders. I always knew that traders are different, but cannot see how Chris sees early 2011 as not favorable for iron condors and from my perspective, I could not disagree more.

It’s not a good year for the strategy, but he has already earned 20%?

I think it’s been a very easy year and have earned more during this period than I have ever as a retail investor (over a comparable period of time). I mention this for one reason: I didn’t have to do anything. No skills required. Just trade the iron condors and then exit. Perhaps a minor adjustment or two, but nothing special. I know these returns are not going to continue. And to be honest, I don’t expect to ever see a five month run that is this profitable again. Nor one as easy to manage.

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Iron Condors: Introduction to Risk Management

One of my oft-repeated messages to option traders is that it is easy to make money when trading options and the difficult part is keeping those earnings. Many of the income-producing strategies win a majority of the time. They are designed to produce more wins than losses.

The problem arises when the stubborn trader, doing whatever he/she can to avoid taking a loss turns a position into a giant loss. That’s the path towards blowing up a trading account. We all say that it will never happen to us because we are too smart, or too disciplined, or too anything else that you want to include.

The fact is that you must be able to apply that discipline when the pressure is on. That means when losses are mounting, the market is not moving your way, and you are pleased with neither what you own nor the chances of salvaging the position. If you cannot pull the trigger when that’s what must be done, then you are in trouble. Warning: pulling that trigger far too early – just to prove you can do it – is also ineffective.

With that as background, a discussion of risk management is necessary for option traders.

Introduction to risk management

Today’s video is a basic introduction to the concept of risk management. It’s 8 minutes of background and general advice, with no specific trade suggestions.



FreeVideoCoding.com

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Danger: Using one trade to finance another

This is a continuation of an ongoing discussion in the comments section. It all refers back to a post from July 2009.

It began with a comment on this post where Mr X (who manages other pepole’s money) proposed the idea of buying a more useful put (i.e., one with a higher strike price) when constructing a collar. Because that ‘better’ put is more expensive that the traditional put (some small number of strikes out of the money) he included the suggestion of financing that more costly collar by selling a put that is farther OTM than the put owned.

In other words, instead of buying a put that affords 100% protection (after paying the deductible) for the other part of the collar (the long stock/short call portion), he proposed buying a put spread. The idea is to buy an ITM put and sell a put that is 20 to 30% out of the money. He provided statistical data that shows that this was sufficient protection more than 99% of the time. That is reassuring evidence for a trader, but the investor who wants the complete protection of a true collar (think Black Swan), this may not be sufficient protection. It is, however, a reasonable choice for someone to consider.

Quoting Mr X:

So you can actually buy a vertical (buy PUT at the money, sell a PUT 20 to 30% lower). This reduces your protection (can still have a major black swan though), but historically it still protects you against 99% of the market drops. And the cost is cheaper (we are saving 20-30% or so on the cost of the protection).

Bottom line: less costly collar, good enough to work 99% of the time (looking back in time does not mean the same results will occur in the future). As I mentioned: a reasonable alternative. The trade is made for a good reason: It costs less, adds to profits (lower cost = higher profit), and is good enough almost all the time. It’s a very attractive idea – for the more aggressive trader.

Summary

The trader has two choices:

  • Own the traditional collar with an (perhaps 5%) OTM put
  • Own a collar with zero deductible (ATM put)
    • This comes with no Black Swan protection

This was my reply at the time:

Overall, I do like the idea of owning the ATM put. But this will not satisfy everyone’s comfort zone. Is it better to avoid the 5% deductible and give up black swan protection? Not an easy decision.

And that was where we left it. An alternative that works better than the collar most of the time, but which leaves the investor facing the possibility of a financial disaster if a true Black Swan event occurs.


That discussion was re-opened recently when a reader commented on the ideas of Mr. X.

One thing led to another and the discussion reached a level where I felt it necessary to post this for other readers.

It is easy to fall into trading traps, and the one discussed by my correspondent is one of those slippery slopes that can lead to blowing up an account. Below is an abbreviated version. The original comment is here

In my mind, this is the progression of a trader:

Step 1: One learns about a put, so they’d like to purchase a put to protect a long position.

[MDW. This trader is off to a very bad start. Learning about puts is not a good reason to buy them. And this really upsets me. One does not BUY or SELL something that is not yet understood. Puts are too expensive for most people to own. It essentially kills any chance to earn profits.

Step 2: To help finance the put, they sell a call, thus they have a collar. They’re willing to part with the stock at the call strike.

MDW: True, it’s a collar. But look what you just did to this poor trader who owned some stock. He ‘learned about’ puts and bought some. Then he sold calls to create a collar. We don’t know that this trader wants to own a collar or even knows what a collar is. This is blind trading for no reason. You are suggesting that this is a ‘step’ in becoming a good trader: Buy a put because the trader learned that they exist (why did he buy and not sell?) and then sell calls just because the trader owns stock and is willing to sell. Two foolish trades. Two steps backwards in an options education. I don’t like being so hard on a loyal reader, but this is not progress.]

Step 3: Like in step 2, they want to help finance the position, so they think of selling a put on the same stock. (this is where you and I agree that this may not be a good idea)

[MDW: I don’t see how this is progress. If the trade is made ONLY to finance the original trade, it is foolish. The discussion you are quoting does not adopt this strategy. Making trades for the sole purpose of raising cash is the (short) path to eventual ruin.]

Step 4: They realize that selling a put on the same stock may not be a good idea because they don’t really want to own it at that strike price.[MDW: Why does the prospect of buying stock at the put strike price occur to you? Not every put seller wants to buy stock. Most traders would cover the put at some future time, rather than take ownership of the shares. There is no indication that the put sale was made for any other purpose than making a trade: Give up the regular collar with its deductible and trade it for a collar with no deductible, but only limited protection. Why is that bad? When I agreed with you originally, I missed the point that Mr X was buying a better put.]

Essentially, they want to sell the put for the wrong reasons and they’re exposed if the stock drops below that lower strike (I think this is where we’re agreeing). [MDW: Not when you explain it this way. In fact, this trader has an excellent reason for selling the put. It lowers costs and leads to profits >99% of the time. What better reason does a trader need, as long as he keeps risk under control by trading the appropriate number of contracts?]

Thus, they try to think of other ways to finance.

[MDW: Why do you believe the trader is seeking other ways to finance? He found a perfectly acceptable method]

Perhaps they could just use existing funds they already have, or they could use the premium from other positions that they would like to own, like by shorting puts on stock B which they are intending to invest in.

[MDW: This trader does not seem to be someone who has any interest in buying any stocks so why would he want to sell puts on stock B? Selling them just to finance another trade is a very poor idea.]

So that’s my thought process of how one gets to this point. The journey doesn’t seem that unreasonable even if individual steps may be ill-advised (i.e. step 3).

[MDW: To me, the journey is dangerous – with each step leading the trader closer to ruin. I do not expect this trader to survive very long]

Thanks.

Tristan,

The big issue for me is that you actively seek ways to ‘finance’ trades. That is a slippery slope that leads to taking far too much risk. If a position is not good enough to own on its own, then it does not belong in the portfolio. It does not have any ‘need’ to be financed.

How does financing the position make it any better to own? Portfolios should be managed by risk and not by how much cash can be collected to finance other positions.

Sure, some trades provide cash that can be used to meet margin requirements of other trades. But making those trades just to generate cash is not smart.

I understand your thinking: If a trader can finance his trades by making other trades that he truly wants as part of the portfolio, that’s a good thing. It keeps the account stocked with cash and eliminates the need to borrow money from the broker.

Look at it from a simplistic point of view. The trader has some positions He seeks to finance them by opening more positions, each of which comes with a net positive cash flow. In other words, the trader sells option premium. Each of those trades involves risk.

It takes a very disciplined trader to recognize when enough premium has been sold. It’s important to prevent over-selling. Once the idea of selling more options to finance other option positions takes hold, it is almost impossible to stop. It will appear to be free money – until the account blows up in one devastating moment.

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Lock in the Profits

Some recent comments have focused on the decision of when to exit a successful trade – a trade with limited profit potential.

Note. This means we are not discussing a situation in which you own some calls (or puts) and the market is going your way. You either go with the trend, take some money off the table, or exit. I can offer no guidance in that type of situation. What makes that so different is that potential profits remain unlimited.

When profits are capped, things are different.I assume that almost every trader who sells a credit spread or a naked option has some price at which covering makes sense. If a trader sells a 60-day call spread, collecting $2.00 and the position can be closed one-week later by paying 10 cents, that almost all traders would happily pay that dime. Fifty-three days is a long time to hold a spread when the most that can be earned is $10.

It’s a different story when expiration is three days away and the short call is still OTM by 5% of the stock price. For the vast majority, paying even $0.05 to cover seems too high.

Do you accept those premises?

If you agree with my conclusions in the two paragraphs above, then there must be some combination of price and time that is an inflection point. Translation: There is some time element, combined with the cost of exiting, that makes the decision a toss-up.

I know that I will pay 15 cents for a 10-point spread (underlying asset = RUT, Russell 2000 Index) even when it is one week prior to expiration. And I’ll pay 10 cents after that. I seldom collect the last penny.

I also pay twenty cents to cover almost any position when it is not a front-month spread. In fact, I’d probably pay $0.25. The point is that I have a price I am willing to pay that depends on how wide the spread is (how many point separate the long and short legs), the nature of the underlying (an $800 index is not the same as a $30 stock).

I don’t believe that traders must have such pre-determined exit points. Risk management decisions are personal and individual. However, I do believe it’s a good idea and I recommend knowing where you would like to exit. Such information can be part of the original trade plan.

From my perspective, it is better to lock in the profits when there’s not much to gain by holding. To others, every penny is valuable and they cover only when they believe it’s the correct move.

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