How Much do I Lose on a 5% Market Decline?

Here's a very simple question from a reader.  And to be honest it's an excellent question and it's something I have never specifically addressed.  I've told readers to do it, but without details.

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Mark,
Just read your post and would like your help on how to most accurately determine how much a portfolio will lose from say a 5% fall?

Underlying:  RUT. 

Here are the Greeks: -50 delta, -5 gamma, +300 Theta, -800 vega.
Thanks for your help,

Simon

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That's a lot of vega!  You did not supply enough information, so I'll make assumptions.  I need the current IV (so we can estimate the new IV, post decline).  I'll use RVX, which is near 35.

Most accurately?  That's a tough one.  You must have a very good estimate of how much IV is going to increase, especially when your vega risk is substantial.  That is difficult all by itself.

A) I would use software – hopefully provided by your broker – that plots positions on a graph.  Look at the position with RUT down 32 points to 614.  Then increase IV by ?? Try 10 and 20% as guesses. Change the date to one day later.

If such software is unavailable to you – consider opening an account at TOS.  No need to fund it.  That should allow you to use their excellent software.

B) Lacking good software, then your next best answer is to break down your position into it's individual option components.  I understand that you may have so many different option series that this is going to be too time consuming.  However, if you own just one or two different positions, then it's probably worth the time to do it.  Find an options calculator.

For each single option in your portfolio, determine the option's value at today's price and tomorrow's price.  For tomorrow's price, use the 5% decline number and once again make a guess as to the future IV.  There is no way around that.  We don't know of there will be panic or relative calm in the marketplace.

Multiply each option by the quantity in your portfolio and determine how much is lost.  It's a good idea to record the new Greeks to help make a similar estimate in the future.  By that I mean it's good to know how gamma, vega change and theta change.

C) If you are willing to accept a less accurate method, then we have to do a 'quick and dirty' calculation – and that's the basis for this post.

1) Gamma.  We don't know the rate at which gamma changes, so let's guess. Gamma is now -5 and will be -10 after the 5% decline.  I admit this is just a guess.  Thus, we have a 32 point decline with an average gamma of -7.5.

2) Delta is -50 and will (negatively) increase by 32 * 7.5.  New delta: -290.

Average delta over the decline: -170 (avg 50 and 290).

32 * 170 = $5,440.   This is the loss from delta

3) Theta.  You get your $300, but theta is almost certain to be higher tomorrow.

4) Vega.  Assuming vega remains near 800, and assuming that IV increases by 10%.  That's an increase of 3.5 points or a loss of 3.5 * 800 = $2,800

Simon, please remember that each of these Greeks is changing.  Just as gamma changes delta, so to do gamma and vega and theta change as the underlying price changes.  Thus,these are merely good guesses.  They work as a ballpark figure.  they allow you to decide whether this risk is too large for you to accept.

Here's where it gets tricky. 

a) The problem is that if panic were to set in, then IV could double to 70.  If that happened, the estimated loss – just from vega alone – would be $800 * 35, or $28,000.  If you were to incur that loss – and if you did not have an margin call and were allowed to continue to hold the position – the question is would you do so.

NOTE: If using Reg T margin and if your positions are protected (i.e., no naked short options), then you will not get a margin call.

b) There is a limit to possible losses.  If you own (for example) 20 iron condors, then it's impossible for the loss to exceed $20,000 minus today's position value.  And I'm sure you understand it would never get that high. 

If the markets were very wide, then your position could get 'strange' closing marks, but I do not believe it's possible for your account to be placed in jeopardy.  But this is a question for your broker, not for me. [What happens if my 10-point iron condor is market a 15 points?  Could I be forced to liquidate?]

Markets can be very wide, but when options are being quoted, the is every reason to believe that it will be impossible to collect >$10 for a 10-point iron condor and I assume that means your end-of-day marks must be in the rational range.  Thus, I assume liquidation is something we can all safely ignore.  But, it is an assumption.

c) If the market does drop that far and if IV does rise that much, I cannot imagine that your loss to vega could be that high.  It fact, at that level, your portfolio could easily be short far less vega.  In fact, when your LONG options are closer to being ATM that the shorts, you will be positive vega.  So the vega estimate is fraught with potential inaccuracies.  That's why the risk graph works so much better than anything else – for your needs.

726


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4 Responses to How Much do I Lose on a 5% Market Decline?

  1. simon 06/26/2010 at 3:41 AM #

    Mark,
    Theres no doubt it’s difficult to assertain how much the portfolio will lose on a 5% drop, there are so many variables at play that are forever changing. I have my brokers software and risk graphs but don’t find them accuarate enough, might take up your suggestion and look into TOS. For now I’ve been crunching numbers as you did in the above post to get an estimate of potential losses, but am never accuarate enough for my liking and can say that in the past after falls around 5% my positions have’nt been hurt the way I would’ve estimated. In some cases being short so much vega didn’t effect my portfolio all that much, just like you mentioned.
    Thanks for taking the time to go through this.

  2. Mark Wolfinger 06/26/2010 at 10:46 AM #

    Simon,
    It’s all a best-guess based on estimates. Human emotions play a big part in pricing options that we can never be certain.

  3. Mark,
    I have a question about probability, delta, and % change.
    When putting a trade together I use TOS charts and have been trying to keep the probability range about 80% and stay pretty delta neutral. I have typically used percentage change as my last “smells good” test. i.e. 80% probability of success, starting Delta neutral, and the range is +/- 10% of the underlying current price. All tests pass, make the trade… This has seemed reasonable when evaluating near term IC’s but when I start looking 2-3 months out the amount the underling needs to move in order to violate a short is huge. What I’m seeing when I look at 2 month IC with a similar probability and delta the range can be as high as +/- 20%! With that range I don’t find the premium to be worth the trade. If I change the parameters for an acceptable premium and with strike prices +/- 13-15% of the underlying the probability drops to around 60%. This looks like a trade with enough premium to satisfy my need for performance and a wide enough range to allow ample time for adjustments but the lower probability could be a worry.
    So my question: Have you used +/-% change as tool in evaluating a trade? Is it a reasonable tool? Am I relying too much on probability?
    Sincerely,
    J

  4. Mark Wolfinger 06/26/2010 at 12:27 PM #

    Hello J,
    1) Yes, it’s a reasonable tool. You must be mentally comfortable with the trade.
    2) You can never rely ‘too much’ on probability. When dealing with stock market events, we are playing in the world of statistics. You will win some and you will lose some.
    Just as must we recognize there is a size limit to each trade, so too, must we pat attention to the probability of success.
    However: standard estimates are not accurate enough because we have learned that the tails of the curve occur more frequently than predicted by statistics.
    All that means is that we must be prepared for the appearance of the ‘black swan.’ It is not quite as rare as statistics predict.
    3) This is not a tool to which I pay a great deal of attention. I’m more concerned with probability than % OTM – when opening the trade. However, I pay a great deal of attention when considering an adjustment. These days 3% OTM makes me consider (and often make) an adjustment. That number used to be zero %, but I am no longer comfortable waiting that long.
    These are truly personal decisions. I would base them on two things: comfort and success. If your plan is working – AND if you believe the success is REAL and not based on good LUCK, then it’s realistic to continue using your parameters. If you are doing very well and recognize that some of that success is due to good fortune, think about becoming more conservative before it hits the fan.
    NOTE: ‘80% probability of success’ is not a term that everyone defines the same.
    a) Chance that the options FINISH OTM
    b) Chance that the underlying never TOUCHES the short strike during the lifetime of the trade
    c) Ignores adjustments that allow you to hold the position for a longer time, and have a winner
    ****d) Probability assumes you are holding through expiration. If you plan to exit earlier (recommended by me) then probability of success increases becasue position is held for a shorter period of time. Profit potential decreases, but to me, it’s a great trade-off.
    NOTE: Two and three-month iron condors do not have to be so far OTM. For example: plan to cover three weeks prior to expiation and the holding period is significantly reduced. The prob of success is significantly increased. You no longer have to be 20% OTM.
    That style (covering early) not be comfortable for you, but it is one way to trade 2 and 3-month options.
    Regards