10 Responses to Risk Management for the Small Trader

  1. Roberto 02/08/2011 at 6:53 PM #

    Hi Mark
    so you are saying that (for example) a ratio 2:1 (take profit : stop loss), it’s not good for an IC, because you’ll lose the most of the time; probably.

    But how about using that ratio on one single leg of an IC, I mean a simple vertical spread, credit bull put or credit bear call?

    For example, i could open a “classical” credit bull put, 10-point spread, credit 200 $ and risk 800 $.
    It’s such a bad idea to set a maximum accepted loss @ – 75 $, and a take profit @ + 150 $?
    This case I think it’s an overall better situation than an similar IC, because here, in a credit bull put, you also gain money if the stock goes up, when an IC lose money, and if the stock goes down, you simpy close when your maximum accepted loss is reached.
    Obviously the example works the opposite way if you decide that a credit bear call it’s more appropriate.

    Of course you may say that thinking and acting this way you’ll find yourself closing losing trades far more often than closing winning trade, but like I read on your blog couple of months ago, you don’t become rich with the win / loss ratio, and also read of someone saying that the “top traders” have a bad w/l ratio, they are wrong most of the time, but they recognize it quickly and limit the loss, otherwise, when they are right they take as much money as they can.

    Am I correct or am I wrong?

    Over the long term will I survive, thinking and acting like this?

    Thanks
    Roberto

    Ps: sorry for my bad english, feel free to correct my grammar if I made big mistakes.

    • Mark D Wolfinger 02/08/2011 at 8:07 PM #

      Roberto,

      I understand you very clearly. You are correct, but your survival depends on the P/L targets for specific trades.

      The problem is not that it’s a 2:1 ratio. The ratio is immaterial – and to be honest depends on how much cash is collected when selling the credit spread or trading the iron condor. It’s a matter of the specific P/L for a specific trade and the probability that of which will come first: the profit target or the loss target.

      The problem is that the position under discussion is a 20-point iron condor, and the credit received was $400. That trade is very likely to show a loss of $150 before it earns the $300 profit. That means this specific spread is likely to be closed – when the loss is $150. For this specific trade, $150 is a very foolish choice – in my opinion – as an exit point.

      If the profit target were only $75 instead of $300, then I would have no objection. Yes, there is still a very good chance to be stopped at that $150 loss, but there is also a good chance of earning the $75 before that happens. With the trade used in the example, the probability greatly favors losing $150, rather than earning $300.

      In your classic spread, you have two chances to collect your profit. First is the passage of time. Second is the stock moving in the right direction. The iron condor does not give the trader that second opportunity to earn a profit because waiting for time to pass is the only path to earning the $300 profit [Yes, a volatility decline would be profitable, but not enough to reach $300].

      Thus, I see nothing wrong with selling a put spread, collecting $200, and setting the limits you suggest. But, that does not hold true for an iron condor. If you were to collect $200 for an IC and use the same targets, I would tell you that your chances of success are very small. Too small to be a winner over the longer term.

      So yes, do cut losses. Do reduce risk. But your profit and loss targets must be designed so that you win often enough to make money. In your example, you must win 1 time out of 3 just to break even before expenses. I believe you would not win that often.

      If I made your trade, I’d target approximately the same $150 profit, but my stop loss point would be more like $300. I’d have to win 2 times out of 3 to get the same break-even results. To be honest, I have not tried to do the math, but I believe I’d have a better chance of success over the longer term than you.

      The trader philosophy of ‘taking as much money as they can’ is a viable idea for some traders. But I believe it’s used by people who own options (or stock) and ride a winner for a long time. They may gain additional hundreds of dollars from a single option. There is not much sense in making as much as you can when the incremental gains are measure in $5 bills. That’s why I cover positions when they become low priced. This is not the best situation to try to earn extra money. The risk/reward is not favorable.

  2. Roberto 02/09/2011 at 6:44 PM #

    Thanks Mark
    but I still don’t understand why you prefer to set a stop loss around – 300 $ in a trade where 800 $ can be the maximum loss.
    In a classical vertical spread, 200 $ credit and 800 $ risk, we agreed that the take profit should be around 150 $, but we disagree about the stop loss, can you do a statical example of why, over the long term, using a stop loss in – 300 $ area, its better than a stop loss in -75 $ area?

    Thanks again
    Roberto

    • Mark D Wolfinger 02/09/2011 at 7:26 PM #

      Roberto,

      I will try to provide a much more detailed reply. Look for it as a blog post tomorrow or Friday morning.

      Ciao

  3. Peter Dengel 02/11/2011 at 7:23 AM #

    Mark,

    Lately I’ve been tracking my vertical credit spreads & iron condors by watching the delta on the short strikes. I usually put on a trade with a delta of 8-12. If the delta goes to around >22, I start to scramble, check the p/l and consider adjustments. Any thoughts?

    • Mark D Wolfinger 02/11/2011 at 8:04 AM #

      Peter,

      There is no single best way to manage vertical spread positions.

      Choosing to accept delta of the short option as THE #1 RISK FACTOR is one of the good methods. All by itself, it is a good measure of risk. I approve.

      My thoughts are you are doing something good for yourself. If delta never reaches your ‘do something’ level, you have a winner.

      One comment that I have is to consider how much time remains – if and when your delta does reach 22. Many times exiting is superior to adjusting.

      Regards

  4. Jeff 02/11/2011 at 10:07 AM #

    I have a question regarding when buyers will exercise their options. I was told this: “If at the end of the expiration period, the stock price is above the strike price, even by $0.05, your stock will almost surely be called away”. That seems odd. Wouldn’t the buyer factor in the premium they paid? For example, if I paid a $0.10 premium for a $15 strike price then I wouldn’t want to exercise my option unless the stock price at expiration exceeded $15.10. If at expiration the stock was at $15.05 and I exercised my option then wouldn’t I effectively be paying $15.10 for a stock worth only $15.05? Please let me know if I am understanding this correctly. Thanks.

  5. Mark D Wolfinger 02/11/2011 at 10:30 AM #

    Jeff,

    The premium paid is 100% meaningless, and no, you do not understand correctly.

    If the stock finishes in the money by $2, then the option is worth $200. If you fail to sell it (a better choice than exercising) or exercise, then you are throwing $200 into the garbage.

    Why would you do that?

    If you paid $500 for the option, you would have a loss of $300.
    If you do not exercise, you would have a loss of $500.
    That $200 is YOUR money. Whether it’s a profit or loss doesn’t change anything.

    In your example, the stock is not ‘worth $15.05. If it trading at $15.10, then it is worth $15.10 The market does not care whether you have a profit or loss, and frankly neither should you. All that matters is whether you are better off exercising or throwing out the cash value of the option.

    One final point: In this scenario, you should almost NEVER want to exercise. Just sell the option instead. Why take the risk of owning stock?

    Regards

    • J 02/12/2011 at 7:36 PM #

      And here is my followup question:

      Call strike price + premium paid = breakeven

      Using such a formula, does it follow that if the stock price at expiration was less than the breakeven then the call would not be exercised? For example, if at expiration the stock was at $15.05 and one had purchased the $15 strike for a $0.10 premium, it seems one would not exercise the option. Yet I have read that options will be exercised if the stock price exceeds the strike price at expiration, which it does in my example, it makes me wonder if there are other factors being considered by the call buyer. One rule, which I assume is adopted by the industry, is that all options in the money at expiration by $0.05 or more will automatically be exercised unless otherwise directed. What other factors could cause calls to be exercised below the breakeven detailed above?

      Perhaps my question was misunderstood. I discussed the issue of selling the call rather than the issue of at what stock price a call will be exercised. I understand and agree with you that it is better to sell your call for any amount rather than let it expire. I also understand what you mean by saying the premium paid is meaningless. Yes, if your plan was to sell the call and not exercise it then the premium paid is meaningless in terms of deciding whether you are going to sell the call or let it expire. (However, the premium is not meaningless if you want to determine if your trading strategy is successful as it represents part of your investment.)

      Also, I think you misunderstood my example in which I said the stock price at expiration was $15.05 and I had a call with a $15 strike for which I paid $0.10. This was interpreted as the stock was trading at $15.10. Perhaps the price relationships I used in my example would not exist in the market. I apologize if I improperly set my example.

      Even so, I am encouraged by how you ended your response: “In this scenario you should almost never want to exercise”. This indicates to me that the risks of owning the stock plus the additional investment required must produce a greater return than displayed in the example before exercising the call becomes likely (at least for you).

      I’m still left not knowing at what stock price / strike price combination calls are usually exercised. I suppose as a buyer it would be when the stock price is greater than the strike price plus the premium. As a covered call seller it probably would be best to assume it would be when the stock price exceeds the strike price. Although this is not technically correct since a call’s price must be greater than zero to be sold, it’s probably good enough.

      I appreciate your efforts to help me with my question. I’m sure when my covered calls expire next week I will have an even better understanding that can only come from experience. Thanks again.
      Reply

      • Mark D Wolfinger 02/12/2011 at 7:52 PM #

        J,

        I will try to explain this to you in a full blog post Monday morning.

        However, right now, I find it difficult to believe that you read my previous reply.

        It’s my job to see that you get a good reply and understand that reply. I’ll do my best to clarify this situation.