Tag Archives | risk management

Short Course in Risk Management: Two Days. Part II

Part I

One risk management tool readily available to the individual investor is the risk graph supplied by your broker.  Those graphs provide a good overall snapshot of current risk.  Along with the profit/loss graph, specific risk parameters – as measured by 'the Greeks' are available.

The Greeks provide valuable information for measuring risk.  When the trader understand potential risk of a given position, it is easier to manage that risk.  However, the Greeks are not the focus of today's discussion.

Let's take a look at a hypothetical SPX (S&P 500 Index) position, assuming that it's Tuesday of expiration week.  As a reminder, SPX options are European style and stop trading when the market closes on Thursday (one day prior to the third Friday of the month).  The final, or settlement price for the index, is calculated, based on the Friday opening price for each individual stock in the index.

Ignoring how you came to hold this position, consider:

Position.  SPX price = 1205

Long 10 SPX May 1200 calls

Short 25 SPX May 1210 calls

Long 25 SPX May 1220 calls

 Let's assume that this is a single hedged position and that you have been managing risk on that basis. [It's always tempting to break a complex position into smaller parts and manage each separately. That's for each trader to decide.  For today, this is a single position]

 

2010-04-20_1902_blog

This risk graph shows the P/L picture for the above SPX position.

The thin blue line represents risk as of today, with three trading days remaining before the options expire.  This graph looks pretty good.  If SPX declines, the loss is small, but if there's a rally, profits continuously increase as the index price moves higher.

The reason the position does so well on a rally is that the 10 extra calls (May 1200s) pick up value quickly.  The positive gamma translates into accelerating profits as SPX increases.

This position is not  all 'naked long.'  There's also the 25-lots of the short call spread (May 1210/1220) to consider.  These spreads lose value on a rally, but the gain from the 10 extra calls is enough to more than offset the loss from the 25 call spreads.


TWO days later

If you are still holding this position two days later, the risk picture has changed dramatically.  Thursday's risk graph is represented by the thick line (labeled 'think' line.  Although that's a typo, perhaps it shouldn't be).  At this point, both potential gains and potential losses are large.

Gains are essentially unlimited on the upside, but there is a barrier between you and those big gains.  If SPX settles (reminder, you will not know that settlement price until midway through the trading day on expiration Friday) in the vicinity of 1220, losses mount quickly.  The protection you owned on Tuesday has disappeared.

A rally places you in a big bind.  If the rally is BIG, you win.  If it stalls near 1220, you lose, BIG.  For most traders this is not a reasonable risk/reward scenario.  Everyone loves collecting theta as expiration nears, but that requires holding positions with negative gamma.  Thus, sometimes there's a big price to be paid to offset all those times when theta collection proves to be the winning choice.

This is too risky for me, but only you an decide whether it suits you and your comfort zone.   I urge you not to trade expiration week – at least not until you consider yourself to be experienced and able to handle risky positions with skill.  Closing your eyes and hoping they turn out well is not the skill set I have in mind.

The main point of this discussion is not taking today's risk graph at face value.  You must be aware of the effects of time an your overall risk.  A few days may seem insignificant – and it is when trading LEAPS options, but it plays a huge role when holding positions during expiration week.

676



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"It is truly amazing how much I have
learned by reading your book.  I had shied away from trading options
because I thought they were too risky for a casual investor who did not have
formal training."

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Short Course in Risk Management: Introduction

In my opinion, there is only one hard and fast rule about managing risk:  You must get it right.  Most beginners accept the fact that it's important to trade very small size and/or use paper trading accounts to gain experience. Few jump into trading with large trades.  There's no denying that sizing trades is the most efficient and easiest method of managing risk.  But that's where risk management ends for beginners.

When a rookie gains confidence because of his/her ability to earn money, it's natural for that trader to want to increase position size.  And making a gradual change is justified. 

However, it's not a string of profitable trades that should be the determining factor.  The best approach is to demonstrate the ability to profit by making good decisions before considering the possibility of increasing size.  This does not mean three consecutive winners. 

It means several months of success – both in dollars earned and in terms of holding positions that do not involve more risk than you should be taking.  It may be difficult for the rookie to tell the difference between good luck and good trade management, but it's necessary to make that distinction.


If I'm making money, isn't that all there is?

Risk management is never considered from the same perspective as profits. Most traders who are able to earn profits – especially when they earn profits as soon as they begin trading – make the unwarranted assumption that they are talented traders.  They don't consider that the market may have behaved perfectly for their chosen strategy.

It's very important to understand the difference between trades that are well-managed and those that luckily end well.  This is a subtlety lost on too many.  The 'obvious' but inaccurate conclusion is often: 'If I made a profit then it was a good trade and I must have handled it well.'

To understand the risk of any given position (or portfolio), it's essential to know

  • How much can be lost, if the worst case scenario occurs
  • How much can be lost today, under unusual market conditions
  • What you have to gain by holding the position; i.e., potential profits
  • The probability of earning a profit from the position as it exists now
  • How theta (the passage of time) affects the position
  • The effect of a large change in implied volatility (vega risk)


To manage risk successfully, you must know

  • What is your first line of defense?
  • When will you take that defensive action?
  •     At some specific number of delta away from neutral?
        When your short option reaches a certain delta?
        When your position loses a specific sum?
        When you get nervous?
        When the risk graph tells you something specific
            Lose $X if the market moves another 2 or 3%?
            Lose X$X if one week passes or if IV drops by 10%?

  • What is your general plan when trouble looms?
  • Will you exit the entire trade?
  • Will you buy back a portion of the losing side?
  • Will you trade shares of the underlying asset to get delta neutral?
  • Will you buy extra options?  Which strike price?
  • Will you roll the position to farther OTM strikes?
  • If rolling, to which month do you plan to roll?  Same?  Next?
  • Do you plan to adjust in stages, or all at once?

As a rookie, you cannot be expected to have the knowledge or experience to prepare a plan with all this information.  But, you can pick a small number of items. 

I'd suggest that you know your first line of defense.  To me that means whether you plan to get out of the whole trade or plan to find a suitable adjustment.

The other important topic is when you will implement that line of defense.

That's a good start.  When you find it's time to make a position adjustment, the decisions you make may help you find another couple of items to add to your trading plan.

Over time, you will develop a sense of what you want to know in advance.  The better the plan, the better you can manage risk.

It's not essential to know these items in advance, but if you do, you will be in much better shape.  You can make decisions, when necessary, even when conditions are stressful.  Having a well thought out plan makes a big difference, especially when you lack the experience or discipline to make good decisions under pressure.  If you have never been short a bunch of puts in a rapidly falling market (with exploding implied volatility), then you cannot know how you will react.  It's far better to have a plan in place and then act on that plan when necessary.

As you gain more experience over the years, as you gain more confidence in your ability to react well under pressure, then these plans will be easier to compile.  If you prefer to make decisions on the fly, and are confident you can do that well (without emotions getting in the way), you can continue making trade plans with rough guidelines rather than specific trade ideas.

But don't give up making those trade plans.  It's good risk management to prepare for contingencies.

to be continued

675


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Exercising at Expiration Follow-up: A real world example

Hi Mark,

Thanks for your suggestions on my DFS trade. In fact I should have mentioned that a majority of my option positions are OTM credit spreads and iron condors.  This is the one or two speculative positions I have at a certain point. I entered the trade back in December anticipating DFS to go up, and it did. I do admit that I committed the sin of being emotional with my position and want to make even, but in this case, I also believe in the company and I do own the stock in another account with a higher cost basis. I was in a similar situation late last year, took a loss but slept well.

1) When you opened the position, and the price you paid are immaterial

2) Your position may have been born short a put spread, but now it's a naked short put

3) You 'believe in the company'?  What does that have to do with the price of tea in China?  Is owning naked long stock (or a covered call) the way you want to play this company going forward?

4) The fact that you own more stock in another account is immaterial.  Although the fact that you are already long with downside risk ought to encourage you to take less risk in this account

The cost basis of your stock is immaterial.  Only the IRS will care about that – if you ever sell the shares.

5) It is not a 'sin' to get emotionally involved with your decisions.  That's a trait that is difficult to overcome, but it is necessary if you want to be a successful trader or investor

It is not a 'sin' to try to get back to even.  However, it is an exercise in bad judgment. You obviously plan to continue to trade.  It should not matter which stock, or which specific position, provides profits.  Your goal is to earn maximum profits with minimal risk.  You are not doing that with this position.

6) One way to break that 'get back to even' mentality is to ignore your entry price for a trade.  Write it in your journal, but do not pay any attention to that price.  Pay attention to current risk and reward.

I recognize that my stance on 'forget about break-even' is the minority view, but I stand by my belief that it's the only view that makes sense.  Consider this:  You hang onto a trade to get one more dime out of it.  You need that one more dime to break even.  While waiting for the dime, the stock moves and you lose two bucks.  Nice risk/reward.  Maximum gain is a dime, maximum loss is ???

On the questions you raised, this is what I think:

Writing covered calls the best play? By the middle of expiration week, I have a couple plans in place:

Plan A: Close the spread with nice profit.   That did not happen 

This an example of you making a trade decision based on profit or loss and not on risk/reward.  It's your money, but this is not a good idea – in my opinion.

Plan B: Short DFS stock so I am completely out of the position by Monday.   I was going to do it on Friday if Plan A didn’t work, but DFS dropped further, so I decided that was not the best time to lock in an exit price 

Again, a decision based on the fact that it would lock in a loss to exit.  This is not a good decision based on risk/reward.  You are free to trade that way, but my recommendation is to learn to think differently.

Plan C: Exercise the $15 call and let the $17.5 call expire; then exit in the near future.  I chose to write covered calls.

A viable plan.  A reasonable strategy.  However, if you chose this backup to a backup plan just to avoid taking a loss, it's no longer a viable plan. 

There is one thing that I did not think about, and that is to roll the position to a later month.  I usually view different expiration dates independently, and I did not have the work done the night before. I guess I should start looking into this possibility. 

Sure, be aware of the possibility. Plan ahead.  If you can get a price you would be happy to get to roll, then this is a good plan.  But rolling just to do something – which is what you did this time, albeit with a weekend long leg – is a bad idea. 

Rolling is not some magical trade that turns losers into winners.  It's a decision to exit one trade and enter another.

Less risky plays? This position as I explained earlier, is one of the speculative positions I have, so by design if I lose 100%, I will be fine with it (on this one, I see that with a little more time I can turn that to a profitable position). I used to speculate with vanilla long calls but I do not feel comfortable with that any more.

When this trade was made, losing 100% meant a loss of $88.  Now it represents a potential loss of more than $1,400.  Are you still willing to lose 100%?  Is this a good speculation?  Are there no other bullish plays that satisfy you?  Must you own stock?

Let me see if I have this right:  You do not feel comfortable with the risk of owning calls, but you are ok with the risk of owning stock? That's not how I measure risk.  But the nice thing about options is that there are so many alternatives that we can each take the risk we are willing to hold.

Naked long over the weekend a good idea? Acceptable, I’m comfortable with it.

Covered calls ONLY because I refuse to take loss? Part of the reason why I exercised, but I also believe in the stock itself.

Gibberish.  If you believe the stock is moving higher  – can't you find a less risky way to be long?

Once again, thanks very much.

Thanks for the question and follow-up.

F.

672


"I thoroughly enjoyed your book “The Rookies
Guide to Options
”.  The book has paid for itself many times
over.  Thank you." VR

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What other bloggers are saying: Becoming a better trader

Here's a comment from Charles Kirk of the Kirk Report.  It's targeted to short-term traders, but the first sentence is appropriate for every trader.  The difficult part is helping new traders understand just how true it is.  So many of them blow their entire trading accounts, and leave the business forever, never recognizing that it was poor risk management that destroyed them.

"Finally, as I've often talked about before, it is my opinion that
what you trade is not as important as how you you manage the trades you
make.

Many people can build high-quality watch-lists but if you
don't know how to spot optimal entry points, how to scale into and out
of positions, have a complete understanding of how to limit loser trades
through position sizing and stop losses, etc. your success will be
modest at best.

Remember, it isn't what you trade that will make you
successful, but rather how you manage the trades you make no matter what
they may be"

***

This useful advice from Dr. Brett won't be of much help to most of us who trade from home or during lunch breaks at work.  But it's important for anyone who is considering becoming a full time trader. 

There are steps you can take to improve your performance, but it takes a great effort.  Find serious traders in your town.  Have get-togethers to discuss business.  That means shop-talk and minimal social chit-chat.  Share ideas.  I don't truly understand the deep psychological aspects of how it works, but just being with successful people and sharing ideas and being a contributor to the conversation brings results.  Perhaps it's confidence building.  Maybe having someone else express support for your trading style is enough to make a difference.  I don't know why it works, but it works.

The difficult part is finding other traders and convincing each other that you deserve to be in such a group.  And for the vast majority who are not professionals, talented beginners can offer each other guidance as you learn together.  Remember, this is a business group.  It's great if you become friends, but the primary function is to help each other become more successful.

Time and again, I've found that
long-term success in markets is not just a function of who the trader is
and the strategies they trade, but also their trading environment.
Being around successful traders can help you become a successful trader;
having the right tools can help you do the job well. As Steve [Spencer] mentions
in his post, the right technology is crucial; proper resources to
assess and monitor risk can make all the difference in one's eventual
distribution of returns.

But it's like growing up in a
dysfunctional home or without a home at all: It's difficult to generate
the right kind of environment for yourself when you've never
experienced one. This is a particular challenge for independent
traders. If you've never been part of a high performance environment,
it is difficult to weave one from whole cloth.

Environment matters. Few people will
challenge themselves to stay outside their comfort zones. An
environment that stimulates you, challenges you, and backs you up can be
every bit as important as the markets and setups you trade.

Note the challenge to trade outside your comfort zone.  I preach exactly the opposite.  The difference is that the expert trader learns to expand his/her comfort zone.  Trying to do that before you are a competent trader, let alone an excellent trader is far too soon.  To become an expert, I agree with Dr. Brett's advice.  But please – this is for the expert trader, not for the beginner and not for any trader who lacks excellent discipline.

671


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The Importance of Having a Trading Plan

Mark,

In my last post I explained how I am in my second month of trading
spreads. I also explained that for this month I entered the call side
first and entered the put side last Friday. As you continue to point out,
the key to being successful in these spreads is how you adjust (or NOT
adjust) not just whether you make or lose money.

At this point, I could
exit my call side (these are May index options) for about a 60% of
max profit. If I exited my put side I would probably lose most of that
profit, and have a slight gain from the whole transaction. the delta on
my puts are about .06 so I am not at risk at this point.

How would
you normally handle this situation? There are many "options" I see, but
most likely are:

1. Close all positions, take a small gain

2. Close the Calls for a 60% of maximum profit and either

a) sell a new call
spread to try and bring in more premium; or

b) do not sell a new call
spread and wait and watch the put spread

3. Do Nothing

Scott

***

I've previously explained my personal methods.  They suit me but may not suit you.

1) The point of adjusting is to prevent loss and to give yourself an increased chance to earn profits going forward


2) When you opened this trade, did you have a plan?  Did you have some idea of WHEN you hoped to exit or HOW MUCH you hoped to earn?

Having such a plan makes these decisions so much easier.  The fact that you lack a plan is why you are asking questions now.

The plan is not the absolute final word.  You can be flexible.

Would your plan call for exiting now at a small profit?  If not, why are you considering doing that?  Are you afraid?  Are you outside your comfort zone?  Do you fear a rally – is that why you want to repurchase the calls?  You cannot expect to be able to continue trading when you don't know he answers to these questions.


3) I always exit my 'winning side' regardless of whether the 'losing side' is in serious trouble.  The problem is when to exit and how much to pay.  I trade my iron condors, collecting about $3 credit.  I close almost any spread at $0.15, and will bid as much as $0.25, depending on circumstances.  That's my plan.  Decide what your plan is.

I don't care about 60%. That's not enough information.  For example, if you sold @ 10 cents, would you pay 4 cents to cover?  You'd lose money after commissions. 

How much would it cost to cover?  That's the key issue.  Are you willing to take the risk of remaining short this call spread at its current price?  If yes, then do nothing.  If you are a bit concerned, then consider covering a few of your short call spreads.  Enough to move you back withing your comfort zone.

If you are covering because you are bullish – that's okay, if you want to trade with a market bias.  There is nothing wrong with doing that.  It's your money.  But be certain that's what you want to do.  There is no shame is risk avoidance.

Selling another call spread is a legitimate way to play this.  But I dislike that idea.  I prefer to establish a plan and not increase risk at any time.  Selling a new call spread brings the position back near delta neutral and that is desirable for many traders. 

I prefer to be satisfied with my target profit – if I can get it – and not be greedy.  To me, selling new call spreads just sets up the possibility of a huge whipsaw.  You are too new to do this.   One major decision you must make:  how much extra cash must you take in to make this trade worth the added risk?  You are too inexperienced to have a good idea.  I recommend saving this idea until you have proven that you can manage risk well enough to take the chance of increasing it.  That does not mean six months.  Take your time.

Keep in mind:  Some extra cash from call spreads provides very little protection if those put spreads get into trouble.  That's why I don't like selling replacement spreads.  Too little to gain, too much chance of losing.

When I cover a call spread, I almost never sell other call spreads as a replacement.

4) If you have no plan write one right now.  Look at your position as it exists right now and make some decisions:

  • When do you hope to be able to exit?
  • How much would you like to pay when that time comes?
  • How flexible do you want to be in the above goals?
  • How much are you willing to pay to exit the call (put) spread?  How much is cheap enough?
  • Does time remaining prior to expiration affect that low price you are willing to pay?
  • When do you plan to take a good look at risk?
  • How high must the delta of your short option be before you plan to adjust; or
  • How much money must you be losing before planning to adjust; or
  • How much time must pass before you would consider exiting the whole thing at a small profit?
  • Anything else that occurs to you

The trading plan offers guidance in making a difficult decision under stress.  If you already have a plan in place, you can execute that plan. 

As a beginner, the more guidance you can provide for yourself – in advance – the easier it becomes.  A good exercise is to look at that plan daily and decide if it's still good, or whether you should revise it.  The point is for you to THINK about your positions frequently and make a plan often.  It is NOT to change the plan.

The plan gives you more confidence because you have already thought about what's important.

It truly helps manage risk.  It makes decision-making easier.

668


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Adjustment Headaches II

To Mark,

Hi John (Addendum: MDW response in blue)


Here's what I do when trading iron condors (IC)

  1. I initiate positions
    without any market bias, which means I do not know whether the stock is
    going to rise or fall or remain in a narrow range.
  2. When the
    stock swings to one direction, not a lot, probably a few points, then I
    will rollover the spread on that side to further strikes.

    How far OTM are your current strikes when you 'rollover'?  Are you adjusting too late or too early?  Most important of all:  Are you rolling just because that's what you always do?  That is not a good idea.  Please be certain
    that the new position is a 'good' one.

    Another thought:  If trading stocks, perhaps the strike prices are simply not very far OTM.  You may be more comfortable with higher priced stocks or index options.  You find rollovers to be unprofitable, yet you do them when the stock moves 'a few points.'  If you are rolling when the stock moves only 5%, perhaps your options are too near the stock price.  Can you move more OTM and still get a reasonable premium?

  3. Doing so allows me to have a good position, but only for the
    moment.
    I still do not know whether the stock will continue in that direction,
    stay there, or retrace.

    That's true for most traders.  If a trader had a market opinion when opening the trade, that opinion has been proven to be incorrect – when the adjustment was made.

  4. This adjustment gives me an unrealized
    loss. My observation is this happens in every adjustment, and the
    reason for this is fairly straightforward. Calling it deferred loss is
    only a matter of opinion. Regardless of how I call it, the unrealized
    loss is real. 

    Yes, it is real.  But it seems to be a 'realized' loss to me. What is your method for the
    'rollover'?  Farther OTM strikes in same month?  Next month? 'Rollover' is
    not the only type of adjustment available.  This is obviously not working for
    you.  Have you considered alternatives?  a) buy back 20% of the short
    spreads and hold the remainder until you feel it's time to repurchase
    more.  This is adjusting in stages, rather than all at once.  b) Buy one
    or two of your short calls.  c) etc.  There are other alternatives.

  5. Since I do not have market bias, I will never know whether my
    new positions will be profitable going forward.

    True.  But if you don't expect them to be profitable; if
    you don't 'feel' good about owning these positions, then don't own them.  Perhaps
    there is a different strategy that you can adopt?  

    The new position is
    just less risky compared to the old one, again, for the moment. Less risky is good, but it's not good enough.  The risk/reward potential must be acceptable. 

  6. On
    the other hand, if I exit the trade, then it will result in an
    immediate loss.

    To me that is not
    important.  If you don't want to own the current position and if the
    rollover doesn't appeal to you, then exiting is a good idea.  Holding onto a trade just to avoid taking a loss means you are going to own bad positions frequently.  When you do that, you are gambling.

    Exiting
    doesn't
    look like a good choice to me because of 3
    reasons: i) if I adjust immediately, theta decay can still come to my
    rescue;

    I don't like this rationale.  If
    you open a brand new position, theta is also on your side 

    ii)
    Exit
    gives no benefit because without market bias, I do not
    know when to initiate a new IC;

    I see
    your point, but without a market bias, isn't it safer to own a new,
    market-neutral, IC than the current position?  Don't forget that 'neutral' is a market bias.

    iii) if
    i exit and stay around hoping
    to roll with better strikes, then I am just guessing the stock will
    continue in the same direction, but I may be wrong.

    The basic decision remains:  Do you feel comfortable
    with the current trade, or would you prefer another?   Maybe you should consider an alternative strategy:  Less volatile stocks; selling options
    that are farther OTM and have a lower delta.  I don't have a specific suggestion, but I sense the
    frustration. I understand that you feel helpless doing what you believe is
    'right' and losing money.  Keep in mind that IC are not suitable for
    all markets.  They only work part of the time.

  7. My opinion is when I adjust, one side of the spread has
    already gone bad. Adjustment prevents it from getting worse. I don't
    see why I would adjust if the stock price stays at the middle of the
    range enclosed by IC.

    When you do that 'unnecessary' trade, it's the purchase of insurance. 

    In other words, I adjust to prevent the bad side
    from getting worse

    Yes, that's one reason.

    As a
    consequence, there will also be deferred
    losses.

  8. Here lies the problem of deferred losses. If the stock
    heads in
    one
    direction suddenly and quickly, the deferred losses are quite big. If
    that stock do this for few days in a row…well you get the idea.
    Although still unrealized, that unrealized loss gives you the shivers.

    I look at risk.  If it's too risky, I get out of the
    trade – either by adjusting or exiting.  Perhaps you don't look at
    adjusting the way I do.  It is not just a risk-reducing trade.  It is
    not just a 'reduce the position size' trade.  It is a trade that gives
    you a good position – a position you want to own.  It does not give you
    a position you are forced to own.  Adjusting is voluntary.  If you don't
    like the trade, don't make the trade.  As mentioned in yesterday's response, adjusting affords profit opportunities.  If you don't find that to be true, then you are not making the best adjustments.

  9. I believe this is the nightmare of IC, apart from a big gap
    that put the trader ITM without a chance for adjustment.

    Yes.  That is one argument for owning insurance in the
    form of extra options.  It doesn't always help enough, but it helps. 
    The problem is that the extra options must be closer to the money than
    your short options, and that makes them expensive.

  10. I
    do not have any solution for this, and market making seems like the
    only valid strategy to me. Everything else has a market bias built in.

    There is nothing wrong with a market bias – if your
    track record shows you have good judgment.  You and I trade with a neutral bias.


The points you mentioned seem to suggest that you know the
stock
will stay range-bound after adjustment.

I
know nothing about the future market.  What I do with an adjustment is
reduce risk, and maintain a position I like.  I suspect your options are
very near to being ITM when you adjust, and that means it's probably
too late to salvage the position.  


Judging from this
phrase:
'believe the position will be profitable going forward'. That is having
a market bias in my opinion.

I
understand how you feel.  When I open an IC position, I feel the
position will be profitable going forward.  If I didn't, I would not
make the trade.  Sure, that assumes a market bias.   IC assumes a
range-bound market.  Every trade has some bias – bullish, bearish, or
neutral.  Not knowing which to choose, I choose neutral.  But that's not
'better' than bullish, it just more comfortable for me  – and 'neutral' has been drummed into my head by risk managers for more than 25 years.  Now I'm the risk manager.

Despite
coming
from a technical analysis
background, I find that market bias is only guessing and consistency
can never be measured.

Well, thanks for reading my rather long details. If you have
something to add, correct, or alternative theory… please
reply. 

I sense your frustration.  I'm  offering advice based on my opinion as to what I believe is
sound.  In the final analysis, it's up to you.

662


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Adjustment Headaches

Hi Mark,

Recently I have some mixed feelings about iron condors (IC), and hope to
benefit by sharing my thoughts here (and hopefully you have some input that
may enlighten me and others who trade IC).

While veterans like you have
mentioned that IC is not a free lunch, I think I have a way to put this
in context. Although IC adjustments are a must for long term success, I
believe these adjustments only make deferred losses (aka preventing an
immediate loss).

If all the positions are closed immediately after
adjustments, then it results in an immediate loss. The
deferred losses pile up as more adjustments are made.

Once
adjustments are made, then the IC trader hopes that the market will
treat him kindly so that theta decay is accumulated by enough to cover the
deferred loss, and hopefully have some left as profit.

But hope is
not a strategy, as you have said.
So my conclusions are:

  • IC does not have a clear advantage compared to other strategies
  • The only feature that makes IC look promising in hindsight is
    the upfront collection of premium

Mark, I wonder you agree with my point of view.

John

***

1) I do agree with your point that IC do not have a clear advantage 

But there is zero advantage to collecting cash upfront, unless that gives you a psychological boost.  An equivalent strategy requires the payment of cash upfront, but the result is the same.  If that cash is the main reason that you trade IC, I strongly suggest that you reconsider, and perhaps find a strategy that is better suited to your trading talents.

2) I don't believe any strategy has a 'clear advantage' over most other strategies.  Some methods work better than others for a given trader because the trader is better equipped to manage the position

a) I believe the 'strategy' tells you which options to buy and sell as your ticket onto the playing field.  You can play the 'options trading/investing' game with a variety of strategies

b) Once you open a position, you are on that playing field. At that time, risk management takes over as the vital factor that determines your eventual success (or not)


5) I don't know how you choose to adjust your IC positions, and that information is not important.  But it's clear that whatever method you are using, it is not working for you

Here is what is important:  AFTER you make the adjustment, do you believe you have a good position?  (If the answer is not 'YES'! then you do not want to make this adjustment) Good being defined as:

a) You expect (not hope) to make money with the position as it is RIGHT NOW.  Not compared with the original price you received when opening the trade.

b) If you have a market bias, then you anticipate a profit when that bias becomes reality.  Neutrality is a market bias

c) If you don't believe the position will be profitable going forward, don't own it.  That means don't adjust the original trade.  Close the position

Adjusting a position is truly the same as opening a new trade.  The major requirement is that the trade is suitable for you.  The one advantage to adjustment is that you save a bit of money on commissions, but that should never be a factor.  If commissions are too high, find another broker.

d) If you look at adjusting as deferring losses, then I don't believe you are making good trades.  Adjustments can be profit centers – they are not only used to 'defer losses.'

Here's an excerpt from an earlier post:

'The bottom
line is that when you make a trade to adjust the position, it's going to
improve what you currently own.  That's why it tends to be a money
maker going forward.  No guarantee.  But you had no guarantee when you
initiated the iron condor in the first place.'

e) My view on adjustments is this

i) The new position is good, meets your criteria for profit and loss potential and fits snugly (with room to spare) within your comfort zone

ii) If EACH of those characteristics is not present, then DO NOT ADJUST.  DO not own this position.  EXIT

iii) Sit on the sidelines or re-invest your money in a fresh position

iv) Adjustments are not made to defer losses.  They are made to give you a good position.  Not a reasonable position, not a position you 'don't mind' holding.  NOPE.  A good position.

v) You have a choice:  Exit and open a new, good position.  Or adjust.  Why adjust if it's not something you WANT to be part of your portfolio?  Why defer a loss and keep a bad trade?  Don't do it.


6) Bottom Line:  Don't think of it as an adjustment.  Mentally think of it as a two-step process.

a) Exit

b) Re-open the adjusted trade


If you would not do b) after doing a), then don't adjust.  If you don't want to own b), then don't own it.

I understand that you may feel this is too simplistic and that it does not truly provide the guidance you seek. The truth is that there is no 'best' answer.  I suggest you do two things, both realistic:

1) Look for alternative adjustment methods

2) Adjust earlier, perhaps in stages

 661


The second issue of Expiring Monthly is coming soon: Monday Apr 19, 2010

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Stock Options: White Hats or Black?

Remember early TV days when the 'good guys' wore white hats and the 'bad guys' wore black?  It was easy to tell them apart.  Today, the white hats of the investment world are seen as wearing black hats by far too many.  Options.  Those are the good guys.

White hats

This post was first published at The Options Zone.

The word
‘options’ evokes a negative emotional response from people who never use them,
don’t understand how they work, and who prefer to remain in the dark.  Many investors truly believe that options are
risky investment tools, used only by high-rollers.  Thus, they make no effort to see ‘what all the
fuss is about.’  Surely they know that
huge numbers (several billion per year) of options trade, but they have no
curiosity.  Why?   I’d guess that an uneducated broker once
told them that options are ‘dangerous’ and are too complicated for the
individual investor to understand.  The
truth is that those stockbrokers were unwilling to learn, and provided a
disservice to their clients.

Today, the
world is more efficient, with useful information (along with misinformation and
hype, so please be careful) all over the Internet.  Options Zone is a safe place to learn about
options, and that’s the reason I accepted an invitation to participate.


Those of
us who understand how options work reap the benefits.  Those who prefer ignorance, must trade with
much more risk than necessary.  For most
investors, bull markets provide profits and bear markets bring the realization
that investing is not a gimmie.
Options are unique.   

The
first obvious difference between options and other investments is their limited
lifetime.  However, the most important
feature of options – the one that makes it an indispensable investment tool –
is that options allow an investor/trader to measure and manage risk. 

  • If you choose not to be hurt during a bear
    market, you can own insurance against large losses
  • If you prefer to use leverage, you can attempt
    to turn a small investment into many times that amount.  This is the ‘gambling’ aspect of options
    that I don’t recommend – but it’s your money and you make the decisions
  • You can own an option position that benefits
    when specific stocks, or indexes, trade in a narrow range.  Or you can own a different position that
    earns money when a specific stock moves much higher or lower
  • Whatever your outlook for the market – bullish,
    bearish, neutral – there is a hedged options trade that earns a profit if
    your outlook becomes reality.  NOTE:  This sentence is not what the hypesters say.  Their line is 'you an make money in any market.'  Sure, but you have to be correct in your forecast.  You cannot take a bullish stance and expect to profit when the market crashes
  • The bottom line is that each of these objectives
    can be attained with limited risk.  There’s
    no need to invest large sums to buy stock. 
    Options can be used to meet the needs of anyone who trades stock,
    commodities etc.

When you
own options, the passage of time is your enemy. 
But you can earn a profit when your prediction comes true.  By hedging the trade and accepting a limit on
profits, ‘time’ risk can be cut considerably. 
When selling options, you earn profits as time passes.  However, other risk factors make this idea
too risky for most investors. Again, by hedging and accepting a smaller limit
on possible profits, that risk can be cut dramatically.

My
purpose today is not to compare the advantages or disadvantages of adopting
various option strategies.  Instead it’s
to point out that you can measure, and reduce, the risk of investing.  That’s why options are special and worth the
time to understand how they work.

More
experienced option traders know better than to try to make money by constantly
buying or selling options and predicting how the market will move.  They understand how difficult it is for the
vast majority to have an inkling of what’s coming next in the stock markets of
the world.

These
investors trade spreads, or reduced-risk, hedged positions.  I’ve discussed the best features of
some basic spreads and explained how to benefit by adopting them (see 'categories' in the right-hand column).

Today,
the idea is to help option rookies understand that options are used to hedge
trades – on a continuing basis – to reduce risk.  Note: options are not perfect.  If you want the combination of zero risk and guaranteed
profits, you are living on the wrong planet.

One
example is the popular strategy: covered call writing.  Investors earn profits when the underlying
stock moves higher, holds steady, or declines by a small amount.  It’s very popular among new option traders,
but serious, experienced investors also use this method.  In fact, there are mutual funds dedicated to
writing covered calls.  The point to be
made is that this method comes with risk. 
If the market tumbles, covered call writers perform better than those
who simply buy and hold the same stocks. 
But, by using options judiciously, risk can be reduced even
further.  By varying the specific options
traded, the covered call writer can enhance the upside or gain additional
protection against a downside move. 
Options are versatile investment tools.

Option
strategies can be used to reduce risk and enhance the probability of earning a
profit.  The profits may be limited, but
the combination of more winning trades and smaller losses is appealing.  Only options can do that for an individual investor.

660

Lessons_Cover_final Are you a fan of Options for Rookies?  Have you benefited by reading
this blog?  Are you one of the many readers who has sent congratulations
and thank you messages for proving valuable content? 

I thank you for the kind words of encouragement.

 


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