Don’t Ignore Risk in a Volatile Environment

As a trader who adopts strategies with negative gamma*, this should be a very difficult period for me.  But, I've been fortunate.  My iron condor portfolio has a few extra long puts and calls, and those extras have served their purpose.

*Negative gamma positions tend to lose money when the market makes a big move in either direction

I don't claim to have taken no losses, but my complex portfolio (20+ iron condors) has performed well.

The point I want to make is that not everyone who buys iron condors is going to be as fortunate.  If you've been having a difficult time because the market swings are too wild and your positions have been threatened with relatively large losses, I want to offer words of encouragement.  Assuming you don't decide to get out of the market completely, there are steps you can take to achieve good results.  No one knows when this volatility will end, but it will end.  For now, it pays to be more conservative.

1)  Reduce size.  That means placing less money at risk, and accepting reduced rewards, during periods of such uncertainty.

2) If you buy iron condors (or sell credit spreads), consider spreads that have strike prices more distant from (corrected) each other.  Again, this reduces potential reward, but cuts risk.  Right now, reduced risk of losing is a very desirable investment objective.

3) It's important to manage your positions with an eye on overall risk.  If you adopt one of the suggestions above, don't feel that you no longer have to bother managing your positions just because the total dollars at risk have been reduced.

4) If you use a strategy (covered call writing or the sale of naked puts) because of your desire to own and/or add stocks to your investment portfolio, give yourself a bit more protection.  Implied volatility is relatively high these days, so you can afford to write options with a lower strike price.  This does reduce potential profits, but it increases the probability of owning a profitable position.

Better yet, you can make covered call or naked put positions much safer by buying OTM puts to convert that covered call into a collar or the naked put into a put credit spread.

5) If you have had poor results and are looking to make a change, keep your wits about you.  If you decide to try a different strategy, please start slowly.  Remember you will be  learning how to use a new strategy, so please reduce the size of your trades until you are satisfied that you understand the new strategy well.

6) If you have been taking losses, please don't take desperate action in an attempt to get even.

Risk management is more important than strategy selection, so keep your risk under control and find a strategy that allows you to remain within your comfort zone when you initiate and hold your option positions.

One final point:  Don't ignore risk management in any environment, but this is no time to get careless.


4 Responses to Don’t Ignore Risk in a Volatile Environment

  1. dave 09/25/2008 at 7:10 AM #

    Thanks for the note it is extremeley encouraging. I for one took some heavy loses on bearish options positions on oex. It was discouraging but at the same time very eye opening. I think with the high implied volatility in options right now it makes options selling extremeley attractive and we can be fooled into selling more options than our accounts can handle or hedging the positions less to get more profits. I certainly appreciate what your are saying about reducing size and thats something I am working on right now. Thanks for your insights.

  2. Mark 09/25/2008 at 11:35 AM #

    Yes, higher premiums makes it seem attractive to sell – but those premiums are high for a reason, so tread gently.
    Be careful if you are selling OEX options. They are subject to early exercise (because they are American style options. Early exercise is a problem because these options are cash-settled.

  3. Mark 09/25/2008 at 4:16 PM #

    After licking my wounds, I sold the following put spread:
    OCT NDX 1425/1375 for $3.00 less commissions. Ideally this will return ~6% at expiration. NDX is currently at 1665 so the strikes are 15% OTM. If NDX rises several strikes I will leg in on the call side. Greek wise, the spread delta is $0.03 and theta is $0.15. The 50 point spread helps keep the theta several times the delta which is a good position to be in (IMHO). I’ll advise on any adjustments I make and comments are welcome.

  4. Mark 09/25/2008 at 7:52 PM #

    I agree that your puts are pretty far OTM, but I must ask: Is your risk manager comfortable with your sale of a 50-point spread for $3.00? Would he allow you to sell a 10-point spread for $0.60?
    I ask because my risk manager would be very upset with me. I’m just curious how yours feels.