Risk Management. The First Line of Defense. Introduction V

The entire concept
of risk management may be foreign to you because it represents a new
way of
thinking.  For example, if a good market timer,
then there's
a high probability that you routinely buy calls or puts.  If you have those skills, you soon sell the position and take
your money. 
But even this simple strategy (highly risky in my opinion) provides an opportunity to exercise good judgment. 

If wrong in a market prediction, the risk-aware trader exits the trade, takes the loss and
moves on to the next trade.  The risk-ignorant trader sees the trade is
not working, but refusing to salvage the remaining time premium, holds
onto those options, hoping for a miracle.  Miracles are rare.  This
trader turns a poor trade into a 100% loser by failing to exercise good
risk management.  And this is risk management on a very basic level. 
Exit a trade when you no longer believe the trade will make money going

In this simple
example, risk is controlled and additional
losses are avoided by exiting the position.

The next problem
for the risk management beginner is
deciding which of a kajillion different adjustments should be made.  In
this situation, experience is the
best teacher and I'll offer guidance with some specific choices for
given trades gone bad.  If you understand the rationale for choosing
each of these trades, then you are very well placed to find different
adjustments because you understand what it is you are trying
to accomplish.  If you memorize one or two specific ways to fix an iron
condor or covered call position, you will not understand the concepts
and will not be able to find your own solutions when facing difficult decisions.

Next, after
recognizing that something must be done to control risk of a given
position, you must get a good handle on when to make that trade or
adjustment.  'When' is easier than 'what to do,' although nervous traders
jump the gun and make far too many trades.

When to adjust
should be part of your trade plan.  If decided well before any trouble
looms, you will in no serious trouble, and able to calmly think
about the problem.  The bottom line is you should make an adjustment
before the trade exits your comfort zone.  You may not have a
well-defined zone at this point in time, but you will develop a good
feel for the boundaries of that zone.

For starters, when
you fear losses; when your stomach aches, when you cannot sleep at
night, it's too late.  You are well outside your comfort zone.

One suggestion for
finding the boundaries of your comfort zone is
to choose a price for the underlying asset, such that if the stock
(index, or ETF) trades at that price, you know risk is too great for
you.  How can you possibly know that?  Use risk graphs
provided by your broker, or buy your own (no recommendations) software.  Those
show you in terms of dollars gained or
lost when specific events occur, such as a change in the stock price. 
But they also show all the 'Greek's associated with the position.

This is not the
place for a lesson on the Greeks, but each of them is associated with a
specific risk characteristic of the position (or of a single option in
the position).  The Greeks do one thing: they measure risk.  Thus, when
any one of the risk factors associated with a specific Greek gets out of
line and makes you nervous, you can adjust that specific risk factor. 
Doing so makes the position safer. 

As you trade more and gain
experience all of this becomes begins to make sense.  This is
overwhelming right now.  But please understand: If you are a rookie
option trader and if you are reading this,
you are very far ahead of your peers who have no concept of Greeks,
risk, or how to make a trade adjustment.  Is this extra work for you? 
Yes it is.  But
go at your own pace.  You are not expected to understand all there is
to know soon – or ever.

I'm offering my
opinion, based on more than 33 years as an option trader.  You do not
have to agree with all of these ideas.  The fact that you think
about them allows you to decide whether you
agree.  At the beginning you will not have much basis to
disagree, but as you gain confidence you will generate your own
thoughts.  If there's something new to try, don't just make the trade. 
Test it and all other theories in a paper-trading account.  Take your
time.  You have the rest of your lifetime to trade.

These posts on the
first line of defense are geared to finding solutions to
the problems outlined.

End of Introduction


I'm offering a couple of free e-books

Sampler version of the Rookies Guide to Options

Introduction to Options: The Basics

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