Risk Management. The First Line of Defense. Introduction III

In a recent
, I suggested that the rookie trader begin by making two
decisions at the time a trade is initiated.   That may be asking too
much of a novice trader, but to stay in the game, to last long enough to
become an experienced trader, the value of your trading account must be
maintained. If you lose all your capital before you know
enough to have a chance to become profitable, then it will be too late to learn how to keep risk at reasonable levels. That's my rationale for asking beginners to make an effort to learn to understand and manage risk by the time they begin trading.

If you already
have a fair amount of experience and never consider risk management to
be important, then I congratulate you on making it this far. Now is the
time to begin a study of risk management techniques and decide how you
can apply them to your trading.

The first step is
to think about the position you plan to initiate (if you already made
the trade, there is still time to prepare for contingencies)
and to consider what can go wrong, how much it may cost, and how to fix
the problem. In general terms, that's risk management for traders.

By thinking about
specific actions to take if certain events occur, the trader gains much
needed experience in developing the skill to manage a position

The trader must
learn to manage money by never having too much capital at risk in any
single trade or any one time, considering the entire portfolio.


You have a bullish opinion on a stock and want to buy some calls,  Ignoring details about the calls, let's just assume you choose something appropriate that's trading at $4.  If your account value is $10,000, even a 10-lot of calls is big size.  The $4,000 cost represents a significant portion of your portfolio and you must have huge confidence to risk that much on a single trade.  My opinion is that there is no possibility of having a confidence level that high (unless you have no integrity and are trading on inside information).

You may like a trade, but do consider what can go wrong.

You may want to own more than a few options and decide to buy 50 options priced at $0.25 because you an afford to invest that much.  DO NOT do that.  Pick the appropriate option and then choose size.  Don't buy the wrong option just becasue you can buy many more contacts.

The successful
trader must learn to manage risk.  Option traders tend to hold trades
for weeks or months, and it's essential to be alert to the possibility that position risk changes. Positions that meet your criteria for managing money may suddenly
morph into positions with far greater risk.  For example, the passage
of time or a change in market conditions (big change in real or implied
volatility) may have a negative impact on the value of your position and
its risk going forward. 

Traders who are
short options – either naked shorts or as part of a spread, must pay
extra attention to the possibility that these options may change from
being OTM and 'apparently almost worthless' to deep in the money
options. It's not good for the shorts if this happens at any time, but
it's more costly when expiration is fast approaching .  [This is the
effect of negative gamma, a topic for another time]

When you own
options to protect against a large market move, the passage
of time significantly hurts their effectiveness.  Especially when
these options are
farther out of the money than the positions being protected.


You sold YZZ 320
calls, and for protection, bought extra YZZ 340 calls (extra means you
bought more calls than you sold).  With several weeks remaining, the
risk graph looks good because a decent rally gives you unlimited upside
profit potential (because of those extra calls).

But, when it's Wed
or Thurs of expiration week and YZZ moves past 320, those 340s have too
little value to be of much help.  In fact, you are now poised to incur a
big loss from the short 320s at the same time that your 340s become
worthless.  This is not the position you want to hold as expiration day

The point: you may
have a position that easily falls within your risk guidelines when the
trade is opened, but that can change as conditions change.  The competent
risk manager is not caught by surprise, but plans ahead.  That can be
accomplished by frequently reviewing positions and both current and future risk.   This should be clear, but let's state it for the record: The original risk is no longer of any concern and you cannot manage risk going forward by looking back in time.

Risk management
involves being aware of how much you may lose when the market
misbehaves.  You must be aware of as many risk factors as you can
comfortably handle.  That's true when the trade is made, and at every
time interval along the way.  It is not sufficient to take a quick
glance at a risk graph.  Instead it involves being certain that the
graph provides all the essential information needed to manage
risk for the specific trade.  Some positions require more information
than others, especially how the position looks as time passes.

to be continued…


Expiring Monthly: The Option Traders Journal

2 Responses to Risk Management. The First Line of Defense. Introduction III

  1. Larry 05/05/2010 at 1:31 PM #

    Mark, I still consider myself a rookie so I have what may be a “rookie” type question. I am selling covered calls and I am seeing that the option/stock price relationship has not been maintained in a way that I would expect. The AAPL stock price is lower than what I purchased it at but the option price is still higher than what I received. (There was a big run up in price before falling back to todays level.)There hasn’t been much passage in time as I bought/sold in April.
    What would cause this? (I have to admit I don’t understand the Greeks yet.)

  2. Mark Wolfinger 05/05/2010 at 2:00 PM #

    Hi Larry,
    This is a common problem and easily explained. a full blog post will be up shortly