Risk Management vs. Strategy Selection

When trading stocks, the idea is to buy stocks that are going to move higher, or as Will Rogers said: "Don't gamble. Take all your savings and buy some good stock. Hold it till it goes up, then sell it.  If it don't go up, don't buy it."

                        

The good news and the bad news about option trading is that it's much more involved than trading stocks.

Option prices don't always move as anticipated because many factors come into play when options are priced.  As we recently discussed when talking about measuring risk using the Greeks, one factor that may drive the price of a call option higher (rising stock price) may be offset by other factors, such as the passage of time or a decrease in the option implied volatility.  Understanding how options are priced, is essential to trading options successfully.  It depends on more than whether the markets are heading higher or lower.

That's the reason risk management is so important when trading options.  The idea behind this post is to help rookies understand that strategy selection is not all there is to trading options.  It's easy to hear someone rave about the profits he/she earned by writing covered call or owning iron condors – but the truth is that such successes are often followed by significant losses, unless the investor/trader understands  how to manage the trade. 

Anyone can write a covered call and profit most of the time.  Only the person who understands risk management can survive serious market declines.  Anyone can own iron condor positions.  In fact, it's a strategy that is touted far and wide on the Internet and there are many advisors who will be happy to sell you costly lessons on how to trade iron condors, and even more who will take your cash, and, for a measly 20% of the profits, will trade iron condors for you.

But the investor who understands how to manage risk can trade those positions without paying large sums to others for either trade execution or costly lessons.  Managing risk – and by that I mean keeping all losses under control – is the single most important contributor to your long-term success as an option trader.

It's okay to take small losses – in fact, it's inevitable.  But eliminating large losses means you will never go broke.  When you trade spreads that have a high probability of being profitable, you will win most of the time.  Couple those profits with small losses and you achieve success.

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2 Responses to Risk Management vs. Strategy Selection

  1. slait73 05/27/2009 at 7:51 AM #

    Hi Mark,
    Some more questions.
    I assume normal parameters with VIX are at the moment a bit distorted, but when do you consider we could say that there´s low volatility? I know now we have less volat than some weeks ago, but I think continues being high…so should be time to trade 2 moth IC´s…?
    (Surently you ´ll tell me you don´t have a cristal ball, but just want to know your thinking of this time o market.)

  2. Mark Wolfinger 05/27/2009 at 8:23 PM #

    What are normal parameters for VIX? I don’t believe the markets we have witnessed over the past 18 months are normal. But I don’t expect to see VIX return to 10 – where it sat as recented as Jan 2007.
    Should we expect VIX to decline to 20? That’s a rough average value. Or should we expect that recent history will affect the markts for years to come and that 30 will become a new low?
    I don’t know how to decide. To me, it’s just a guess.
    What I am doing is to play the game vega neutral. To accomplish that, I have some iron condors and I also own enough strangles to neutralize vega. Instead of strangles, double diagonals are a reasonable alternative to add vega to your portfolio.
    I will not want to get long vega until RVX is near 25 – and that would require another large decrease. My guess is that if RVX is 25 VIX will be near 20.
    My thinking is that I am not willing to own 3-month iron condors. I am not willing to be short vega with options that expire in 3 months – when IV is at current levels. Thus, I’m choosing 2-month positions.
    But there is nothing wrong with one-month iron conodors is that suits the comfort zone of slait73. It doesn’t suit my comoft zone, but that’s because front-month iron conodrs have too much negative gamma for me.
    I have no crystal ball. But for now, I’m playing it safer: smaller positions; 2-month, rather than 3-month positions; and vega neutral.