Risk Management. The First Line of Defense. Introduction I

I recently posted a (very) short course on risk management.  After due consideration, I decided that this aspect of trading is so important that it's worthy of a much more detailed discussion.  For anyone who trades with 'guts' or 'feel' or by the seat of his/her pants, you may believe this is an unnecessary discussion.  If you talk to successful traders, you will discover that almost every one of them will tell you that risk management is essential to long-term success.  I'll go further than that:  If you are neither a skillful risk manager nor a very lucky trader, your trading career is not likely to last a long time if you are unaware of, and thus, ignore, risk.

That's the rationale behind this series of posts which continues the discussion, in depth. As I write, I don't know where this is going, but I know where to begin. At the beginning.

This gives me the opportunity to write about my philosophy of trading. I've developed some ideas over the past 33 years of trading options. Some are universally accepted – which means I didn't really develop them, I borrowed them. Other ideas represent my point of view, which in turn, came from my experience as a trader. Risk management ideas from this perspective should be useful because it offers detailed suggestions as well as specific guidelines. [Some of these ideas are presented in Lessons of  a Lifetime, my recent e-book]

I encourage you to think about the suggestions made here. This is not physics or chemistry in which someone can lay out the laws that have been proven to be accurate by experimentation and testing.  I offer ideas that seem logical to me. They represent the truth as I see it. However, the advantage for you is that you can think about these ideas, try them, modify them, and then you may elect to disagree with them. It's real life science in which you experiment with an idea, and then adopt it or reject it as you develop your own theories about how best to manage risk.

My task is to see that you come to recognize the importance of risk management and to get you thinking in a manner that will serve you well.  Your task is to ask questions, think about what you are doing, and not blindly accept every suggestion being made. 

Learning to pay due respect to risk is easy once you get clobbered a time or two.  I'm suggesting you save yourself that ordeal by taking risk and money management as essential parts of trading.

Learning to limit risk (at all times) is similar to learning about, and choosing a specific option strategy to trade. Successful traders don't adopt a single trading idea (strategy) and use it forever. Different market conditions are far more friendly to certain strategies (and a strategy is merely selecting which options to buy and sell to form a position) than others. As conditions change, the intelligent trader is flexible enough (i.e., not stubbornly adhering to a method that is clearly not working) to select alternative strategies and reduce position size. Similarly there are many ideas you can put into play when keeping risk under control.

I recently asked a well-respected trading coach whether I was over-emphasizing risk management to the beginner, wondering whether it would be better to allow that rookie to gain some experience before making the effort to understand why risk management is so important. The reply was 'no' – I was not overstating the importance of risk management. In fact, he told me that the rookies' trading career would likely be very short if he/she did not get on board with managing risk almost from the start of trading.

The truth: I enjoy writing instructive posts, but I'm not writing for myself. I want to help you learn to use options profitably. I want you to avoid mistakes I made – and believe me, ignoring the importance of managing risk is at the top of the list of my trading sins. If I can help you steer a smooth course through the jungles of trading, then your life will be a lot less stressful, and happier. With that purpose in mind, I'm beginning a detailed foray into the world of risk management.

This is not going to be a mathematical treatise. Indeed, it's not only targeted to rookie option traders, but also to anyone else who has not paid enough attention to managing the risk of owning option positions. And for those who do have a decent understanding of how to keep risk in line, there should still be useful tips. With that in mind, let's get started.

There is much ground to be covered, so please have patience.

To be continued


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14 Responses to Risk Management. The First Line of Defense. Introduction I

  1. Josh 05/03/2010 at 4:38 PM #

    Hi Mark,
    If I wanted to collect IV premium and theta decay, had a low-commission account with portfolio margin (Interactive
    Brokers), and was comfortable with the risks involved, would selling OTM puts and calls and using the e-mini S&P futures as a tactical hedge be viable? Based on my research, I would probably stagger the call and put selling to reflect the market’s historical tendencies.
    For example, if the market is up 5% over the past month I would sell a suitably far enough OTM call, based on the past odds of a strike price breach. Plus I would have a market stop buy order for the e-mini, calculated to take into account estimated increased margin requirements. In other words, the e-mini stop wouldn’t be exactly at the call’s strike price, since the portfolio margin system would already be “demanding” increased margin. I also wouldn’t be using the
    full margin available at the time of the call sale (I’m not insane :).
    For the put sale, the method would be the same, i.e. tactical, and ideally I would always be short an equal number of put & call contracts, but the sales’ timing would be staggered, so as to capitalize on different IV in different situations, and the odds of a continued change in price. I know there is some directional bias in this and I’m comfortable with that. Also, I know that my e-mini stops
    would be at risk for 15 minutes per weekday, and over the weekend, but I’m comfortable with that as well.
    What are your thoughts?

  2. Donald W. 05/03/2010 at 9:36 PM #

    You certainly do not over emphasis Risk Management a bit. I was hoping to learn as much from you as possible in this area. I sold XLF 17 put last month for .69 and was expecting it to move above 17 and keep premium, but as it would go it drop quick with Washington investigation of GS. Not thinking Risk Management through I did nothing until today and roll to June 17 for a small credit. Hoping that your Risk management blogs will help me be better prepared in the decision making process next time.

  3. Mark Wolfinger 05/03/2010 at 10:04 PM #

    I hope so also.
    The main point is to be prepared for being wrong and deciding how ‘wrong’ you are willing to be before taking action.
    Then of course, choose an appropriate action. It’s your account, but I would not want to extend my risk for another month when the put is already ITM. Unless the premium is BIG not small.
    But if you want to take a bullish stance, that’s not the same thing. This is one way to place a bullish bet with limited gains, and larger losses possible.
    I’m trying to lay out my thoughts on a variety of subtopics. These posts have not been written too many days ahead. It’s a work in progress.

  4. Mark Wolfinger 05/03/2010 at 10:36 PM #

    Yes, it’s a viable approach. Obviously selling naked calls and puts has far more risk (and reward) than trading iron condors. But if you are comfortable with the risk, then this can work for you.
    Using the e-minis (although I’ve never traded any) is essentially the same as using stock to manage delta risk. [Other readers could buy DITM calls or puts to adopt this method].
    This is also viable, and is used by many traders. I understand this method is very attractive because it costs zero theta, and as premium sellers, we love our positive theta. Speaking for my trading style, I don’t like this method for adjusting positions. There are two major reasons.
    First buying futures provides only delta. It offers zero gamma, and if an adjustment has become necessary, then gamma risk has increased significantly since the position was opened. I prefer to buy some positive gamma when adjusting. That’s just my comfort level speaking.
    Second, whipsaw possibilities. If the market reverses, my adjustment using options is not very costly. But it can be expensive to sell those e-minis after buying them on the rally.
    This is obviously a trade-off. Larger profit potential in exchange for more costly adjustments (when they have to be reversed).
    One comment: I don’t believe it’s essential to sell an equal numbers of puts and calls, but I would not stray far. If trading small, 2 puts and one call is not a good ratio. But, 51 calls and 48 puts is fine.
    Josh, the major factor in making this work is having the discipline to make adjustments as needed. It seems to me that you have thought this out and can manage the risk.
    Good trading.

  5. Josh 05/05/2010 at 11:14 AM #

    Thanks Mark,
    Yes, as far as discipline goes, I’ll be using stops resting on my broker’s servers; one of the main reasons I’m a systems trader is I much prefer learning and researching about markets over actually trading, and just as Dr. Brett at Traderfeed says, developing that “performance skill” and discipline takes a lot of time. And I already spend way too much time in front of a computer!
    I understand that I’m only gaining delta with my emini hedges, but isn’t the effects of gamma sort of irrelevant for my strategy? I mean, since my method of adjustments involves the futures and not changing my option positions, I don’t see how it is more than a paper loss, unless I were to abandon the strategy and buy the options back.
    Thanks again,

  6. Mark Wolfinger 05/05/2010 at 12:10 PM #

    1) The reason why your strangle requires an adjustment periodically is becasue delta risk has increased to the point where a fix is desirable.
    2) Your position began as delta neutral. So why is it ‘un-neutral’ later? Because negative gamma changes the delta of each option in your position.
    3) When you make the first adjustment, gamma is no longer near zero. And gamma accelerates as the underlying continues to move. That means your position delta is going to move against you even more rapidly that it has to date – if the market moves in the same direction.
    4) When an adjustment is purely delta and zero gamma, nothing is done to adjust gamma risk. To me, gamma is very relevant.
    That’s why I prefer to pay negative theta to adjust with options. I gain positive gamma, and that reduces the rate at which losses grow.
    From my perspective, delta risk is obvious, but gamma represents the true risk of a position.

  7. Josh 05/05/2010 at 9:50 PM #

    Maybe I’m not thinking of “adjustments” in the traditional option traders sense. The way I’m thinking, is that I will buy or sell one emini per 5 SPY contracts (or wherever the premium is best) depending of course on whether the put or call is threatened. Since each emini is equivalent right now to about 60k of stock, until my account grows, the hedges are relatively rough, binary on/off so to speak. I thought that I might be over-hedging at times, since delta can’t (or theoretically shouldn’t) go past 100 (or -100). So if for example, I’m short 10 SPY 1200 calls, and S&P breaks through my pre-calculated margin/pain-threshold I would buy 2 eminis. With the calls still OTM at the exact time of the emini purchase, although gamma increases, and therefore delta as well, aren’t I already at the max delta-wise hedge necessary for the position?

  8. Mark Wolfinger 05/05/2010 at 10:10 PM #

    I know nothing about e-minis. If you buy one, you say that’s 60k worth of stock. Why buy 2?
    If you have 5 SPY contracts, unless these are 100 delta, the SPY options do not move like 60k worth of stock. Wouldn’t this trade make you VERY long?
    I don’t want to confuse you. E-minis represent another world and I am not qualified to say anything about them.

  9. Josh 05/06/2010 at 4:40 PM #

    1 emini equals the S&P index times 50… so around 60k with the S&P near 1200. (rarely do the futures have more than a plus or negative 4 premium/discount to the actual spot index) So 500 SPY shares controls an equivalent dollar value of stock as one emini. Hence 2 eminis for 10 SPY contracts.
    So that’s why my hedges would not be like an option market maker who is constantly buying or selling just the right amount of stock. I’m buying in 60k chunks at a time, so I don’t have the ability to get as close to delta-neutral as someone buying or shorting stock.
    As far as I understand it, I have to compromise and either be too long or too short when defending my strikes, at least with using the emini futures. I guess its a trade-off between lower margin requirements of futures versus ability to stay more delta neutral with stock.

  10. Mark Wolfinger 05/06/2010 at 7:12 PM #

    OK Josh,
    Lets say you sold five Deep ITM SPY calls and SPY is 1200 (that number looked more realistic recently).
    To hedge you buy 2 e-minis.
    60k of stock vs 60k of stock. This is very similar to a covered call position.
    First question: Do you agree with the above?
    When SPY is less than deep ITM, when it’s below the call strike price – as it was in your example, you do NOT want to own 2 e-minis as protection.
    You would have $60k worth of stock to hedge a short SPY position worth less than $25k. This is not a reasonable hedge.
    To convince yourself this is true, look at the e-mini and option prices at yesterdays close and today’s close. You should see a big loss in a 2 x 5 hedge.

  11. Josh 05/09/2010 at 3:43 PM #

    No, I definitely would hedge with only 1 emini… I think my choice of words for my example was confusing. Sorry.
    One emini per 5 SPY calls (or puts).
    And for sake of clarity, if I was short one SPX call I would be hedging with 2 eminis.

  12. Josh 05/10/2010 at 12:39 AM #

    I see what you’re saying about being long 60k of stock futures versus being short OTM options with a notional value much less (until they’re deep ITM).
    I’ve left parts of my strategy out and I think that has caused some confusion… after reading up on gamma scalping it seems like what I’m attempting to do is pretty much the same but with futures.
    My emini “stops” are actually dynamic trading programs with an end result somewhat similar to gamma scalping with stock. For the sake of space, I chose the term stop-loss, but obviously that was a bad choice. Sorry for the confusion!
    Anyway, Mark, I appreciate your responses.

  13. Mark Wolfinger 05/10/2010 at 7:22 AM #

    It’s impossible to gamma scalp and make money, if you want to trade dear delta neutral – when you have negative gamma.
    Good trading.

  14. Josh 05/11/2010 at 1:48 PM #

    Perhaps delta-neutral isn’t what I’m going for. There’s obviously holes in my options knowledge so I’m glad you’re here to patiently answer questions for newbies like myself.
    Thanks again, Mark.