Risk Management: Making those First Critical Decisions

The topic of managing risk was introduced in a five part series. It's time to get into more of the details.

Risk Management: Choosing the first line of defense

When you own a position that can lose money and continue to become
riskier as market events unfold, the first two concerns (at least my
recommendation is that these be placed at the top of the list) are:

  • What specific action will you take before serious
    trouble arrives?
  • What has to happen to trigger that action?

Let's consider a simple (commissions ignored)
example. Writing covered calls:

You invest $5,400 to buy 200 shares of XYZ @
$27 per share

You write two
calls, expiring in 60 days.  The strike price is $25 and you collect a
premium of $350 for each option.

Your
cost basis (or break-even point) is $23.50 per share.  In other words, if the stock is above $23.50 when expiration arrives, the trade is profitable.

When owning a covered call position, you recognize that when this stock is above
the strike price after those 60 days pass, you
will be assigned an exercise notice and sell your shares at $25.  Net
profit in this example is $300.

If the stock moves higher and higher prior to expiration, nothing is lost and risk does not increase.  The higher the price, the greater the probability that you
will earn that profit.  Some traders find a rising stock price to be upsetting.  Don't let that happen to you.  You chose a strategy, are about to earn the maximum possible reward from that strategy, and a rising stock price makes it even more likely you will win.  You win.  Don't let anyone tell you this is a loss.

If a rising stock price is good for your position, then it's likely that a falling stock price is not.  There is risk of loss when the stock is below the strike price ($25) at expiration.  After 60 days, the calls expire worthless
and you own the 200 shares @ $23.50. That's better than the $27 you paid for the shares, and writing the covered call option has been beneficial.  However, the position had little downside protection, and if the stock falls far enough, this position may be losing money and threatening to lose even more.

There must be some point at which you take action to reduce future losses, and  increase the chances of making money going forward.


Time out

'Going forward' is a key phrase.  If you want to be a successful trader this is an important, albeit controversial, concept to grasp.  Most traders – both experienced and new – have a blind spot in a situation similar to this.

The usual method of evaluating a position is based on the original trade – and the price at which that trade was made.  I take a different view.  To me the original trade is history and no longer relevant.  I examine a position as it is priced right now – and then decide if I want to continue to own the trade at its current price.  What matters to me is the risk/reward going forward as well as the probability of success.  If the position is currently profitable plays no role in my decision.  I either want to own it or I don't.  If not, I exit (or perhaps make an adjustment instead).  Only after the trade is closed do I worry about whether it made or lost money. And that's for the purposes of record keeping.

If the position is currently under water (losing) the general plan for the majority is to base a strategy on the chance to earn enough to eliminate the loss.

This is a psychological trap that hurts your profitability. I hope to convince you to avoid this way of thinking.

When trading, your top goal is to make money with an acceptable level of risk. You do not care (or should not care) which position produces those profits.  You don't care which stock provides those profits.  Your job is to gather those profits.  You already understand the concept of making money.  Managing risk is another, and more important, job.

I know some believe that if you make money, nothing else matters.   And I suppose that idea sounds reasonable.  However, if you are taking much more risk than you realize; if you are getting good results because nothing bad has happened; then sooner or later statistics become reality.  Those '90% chance of winning' trades are expected to lose approximately one time in 10.  Yet, when it happens, the trader seems to be unprepared.   It's as if he/she believes it should never happen, and that 90% truly means 100%.  If unprepared, a single loss can wipe out years of gains.   

Thus, getting back to even is a meaningless goal (in my opinion).  Your goal is to make money today and into the future. If one position cannot do that for you, exit, take the loss, and find another that you believe will be profitable.  If you can 'fix' or adjust this position so that it fits within your definition of a good position, then that's a reasonable alternative.  But don't force the trade.  If you cannot fix it, dump it.  Too many traders only heed that 'dump it' advice when the trade is profitable and almost never, when it is losing money.

End of time out


Most investors/traders would continue using this basic strategy (covered calls) to write another option if the first call expires. 

When this stock is trading under $25 per share, and you own stock after the calls have expired, i recommend that you ignore your current cost basis (that's $23.50 in this example).  I recommend that you look at the stock as it is priced today – and decide what to do.  You can hold, you can sell, or you can write another covered call.

Conservative traders sell the 22.50 or perhaps 20 strike call.  They recognize the importance of selling an option with some protection against loss (if the stock continues to decline).  That downside protection reduces risk when owning the covered call position. 

If you understand the concept of accepting a reduced profit when the stock rallies beyond the call strike price, then you already grasp the basic concept of good risk management.  You are trading potential (and that's all it is – potential profit) for additional safety.

The more bullish investor may prefer to write a call with a strike of 25, and that's okay when the reason for the trade is to bet that the stock moves higher.

However, if the decision to write the 25 strike call is based on a mindset that demands making a trade that offers the opportunity to get back to even, then it's a poor decision.  You want to make money from today onward.  You cannot be concerned with money that has already been lost. 

The concept of 'making money going forward' is not often discussed, but there is plenty of talk about break-even prices.

The money has already been lost, and the best way to 'get back to even' is to find another profitable opportunity.

The 'get even' mindset is not one that's in tune with good risk management.

to be continued…

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6 Responses to Risk Management: Making those First Critical Decisions

  1. Josh 05/17/2010 at 5:14 AM #

    I can’t agree with you more about the negative effects of trying to get even on a trade. I think this is conceptually similar to the idea of “playing with the house’s money”, which is equally wrong.
    There’s a classic tell in poker, where, if another player has a stack of chips separated from his main stack, it often will be his winnings. So to take advantage of this, one would bet (for a bluff) more than that amount, since people don’t like to go home with a loss. If you actually think your hand is better than his, you would bet less than that, hoping he’ll call the bet. (And not really relevant, but if you’re playing against knowledgeable players, you could separate part of your stack, to try and induce other players to bluff too often)
    Trying to get back to even usually means taking on more risk without any comparable increase in edge, and trying to stay above even is the converse, reducing risk when it isn’t warranted, which is an opportunity cost.

  2. Mark Wolfinger 05/17/2010 at 8:51 AM #

    John,
    Mindsets, or points of view, are difficult to change – once a trader believes them.
    Stack separation is a mind game and will work against unskilled players.
    ‘Back to even’ is a losing way to think. Yet, not everyone agrees.
    Regards

  3. Bill 05/17/2010 at 2:00 PM #

    Hello Mark:
    You may recall that I contacted you back in January and presented some pretty ridiculous (in retrospecr) questions about options trading. Bottom line was, I needed more education.
    Starting in February, I began selling covered calls with increasing success going forward into March and April. However, the wobbly market in May and the huge 6 May spikedown has resulted in mild losses for the current expiration period. Covered calls don’t work well under the current circumstances!
    I have continued my research and education and I feel I may have spotted an excellent trading concept relating to options. Simply stated, this consists of writing covered calls and then protecting the underlying long stock position with a “costless collar”. The collar provides essentially 100% protection on the downside and contributes further to gains made by the covered call on the upside.
    My question is, is the above assumption valid (i.e, correct)? It seems a little too simple. As my wife puts it, if it’s so “foolproof” then why isn’t everybody doing it?
    Thanks in advance for your time taken to address this issue.
    Bill

  4. Mark Wolfinger 05/17/2010 at 2:18 PM #

    Hi Bill,
    Keep on learning. That’s one of the top secrets.
    Covered call writing is a bullish strategy, and does not do well when markets fall. That’s the negative side to that method.
    There is nothing unusual about your ‘discovery.’ Collars represent a worthwhile, conservative method. Costless is even nicer, but you have to be willing to accept very limited upside profits.
    Two points:
    1) You cannot get a costless collar with 100% downside protection. You can get costless collars, but the put will have to be out of he money and there will be some potential loss.
    2) Collars are also mildly bullish. That may not be obvious, but the collar is equivalent to selling a put spread – with the same strikes and expiration as the collar. That means there is going to be some downside risk.
    The puts are just coo costly and you cannot find a call to sell that offers gains to the upside and a premium large enough to cover the cost of the put. You may be able to come close, but you will probably not like the very limited upside.
    2) Give the wife a gold star
    Regards

  5. Ross 05/17/2010 at 6:35 PM #

    Mr. Wolfinger, I have been practicing swing trading stocks using the Think or Swim platform. Is it possible to practice paper trading writing covered calls realistically? I ask because of the part where someone may choose to exercise their right to buy the stock. How would that affect my paper trading of writing covered calls, if at all?

  6. Mark Wolfinger 05/17/2010 at 7:10 PM #

    Ross,
    Almost no one ever exercises a call option prior to expiration. It’s a stupid thing to do and you can assume the chances of its happening are tiny. Thus, you can safely ignore that possibility and it will not affect your paper trading results.
    There is one exception. If the stock pays a big enough dividend, then it becomes a good idea to exercise some options for the dividend.
    Those must be in the money, have a 100 delta, and there must be zero time premium remaining in the price of the option. Otherwise exercising is a losing decision for the call owner.
    If you choose to practice this strategy, it’s better to choose stocks with low dividends, or no dividends.