Considerations when Managing Risk. I

The most important factor that determines your success or failure as a trader is how well you manage risk. I don’t have statistics to provide proof. However, I do have my 34+ years as an option trader. I know what has happened in my own account and have been privy to the highs and lows of other traders.

If we accept the premise, then we ought to understand how a trader ‘manages risk.’ It’s not as easy as saying: ‘I will never take a large loss.’ There are many intermediate steps. Let’s discuss a few of them.

Part I of a series.

This idea goes at the head of the list. When the maximum possible loss for a given trade is not large enough to hurt the trader, then the first and easiest requirement has already been accomplished.

On the other hand,if we always think about the worst possible loss, our trades may be too small to generate reasonable returns on both our investments and our time. It is therefore prudent to consider the maximum loss that is likely to occur. When someone sells a naked put option with a $60 strike price, sure it’s possible to lose almost $6,000. But that is such an unlikely event, and is even more unlikely to occur without some chance for the trader to exit that it makes no sense to use that figure when determining position size.

Similarly, when selling naked calls, it is not feasible to assume an infinite loss.

We must make a reasonable estimate of how far the stock will fall on bad news as our worst case scenario. More importantly, if the stock merely moves steadily in the wrong direction, we must have a point at which we would stop the bleeding, abandon the idea of more adjustments, and just accept the fact that this trade is not, and will not become, a winner.

If our trader is willing to lose $3,000 on a given trade, and if he/she plans to exit when the trade loses $300, then 10-lots becomes the maximum size for this trade. [Addendum: The ‘$300’ refers to the loss per spread. Thus, a $300 loss x 10-lots places this trader at the $3,000 maximum total cash loss that is part of the trade plan.]

Next, we consider the worst case scenario where bad news (and bad luck) arrives. If we deem the potential loss to be ~$600 per spread, then we may want to reduce size to perhaps 8 contracts.

If you think the chances of that $600 loss are high enough to cut your size to five spreads, then this is not the stock to be trading. You can find a stock that is less likely to make that anti-positional move. Or you can trade this stock with a less risky strategy.

The conclusion is that we must know how much can be lost per spread under normal circumstances, how much loss, in dollars, we are willing to accept, the possibility of a much larger loss, and trade the appropriate number of contracts.

Don’t believe that this process is only for those who sell option premium and have negative gamma positions. For long gamma traders, big losses may not occur overnight, but that ticking clock can destroy a portfolio just as completely.

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2 Responses to Considerations when Managing Risk. I

  1. Bill 04/11/2011 at 8:16 AM #

    Hi mark,
    I don’t understand this:

    If our trader is willing to lose $3,000 on a given trade, and if he/she plans to exit when the trade loses $300, then 10-lots becomes the maximum size for this trade.

    Next, we consider the worst case scenario where bad news (and bad luck) arrives. If we deem the potential loss to be ~$600 per spread, then we may want to reduce size to perhaps 8 contracts.

    How do you come up with these 10 lot and 8 lot figures?

    Thanks,
    Bill

    • Mark D Wolfinger 04/11/2011 at 8:52 AM #

      Hi Bill,

      I came up with 10-lots because losing $300 * 10 gives the trader a maximum loss of $3,000. And that’s the figure used by the trader in his/her trade plan.
      I came up with the 8-lot as described below. A randomly chosen idea for reducing risk. Of course, that idea comes with reduced profit potential.

      I’ve added an addendum to the post that I hope clarifies the situation.

      a) Losing $300 per spread translates into a $3,000 lost for a 10-lot position.
      The trade plans calls for the trader to exit at this point. That does not mean that the trader – with a very good reason – cannot change the plan. However, if under stress or panic, that is a poor time to make such a decision. If an adjustment had been in the trader’s mind, and if that adjustment truly reduces risk, then it is surely a reasonable alternative. However, making that decision on the fly is difficult, and should have been incorporated into the trade plan [once that alternative was discsovered and approved bu the risk manager persona of the trader. Obviously this could not be part of the original trade plan].

      b) If you are referring to the next paragraph: We all have plans to exit at specific times or price points or when losses reach a specific level. Rarely – but certainly more frequently than never – the market gaps and out planned exit has been overshot. We nay have wanted to set $300 per spread as our worst loss before exiting, when something unusual happens, we can lose (or earn) more than described in our original plan.

      We can play extremely conservatively and trade only half the planned position size – allowing for this unlikely event. Or we can make a minor concession to that possibility by reducing position size by a smaller amount. I’d hate to trade 8-lots consistently with that fear of an unlikely event in my mind. However, there is no need to ignore that fear,and trading a slightly reduced number of contracts may be good enough for the trader to feel okay with his/her position size.

      This discussion is not meant to present iron clad rules. In fact it is offered as a way to get you thinking about several factors when the original trade is planned. There is nothing wrong with deciding that you don’t want to take extra precaution for events that occur once per year. But that is a decision based on whatever factors you decide are important. What is a bad approach to trading is to ignore those unlikely events. There is a big difference between making a decision to do nothing and not even taking the time to form a decision.