Short Course in Risk Management: Introduction

In my opinion, there is only one hard and fast rule about managing risk:  You must get it right.  Most beginners accept the fact that it's important to trade very small size and/or use paper trading accounts to gain experience. Few jump into trading with large trades.  There's no denying that sizing trades is the most efficient and easiest method of managing risk.  But that's where risk management ends for beginners.

When a rookie gains confidence because of his/her ability to earn money, it's natural for that trader to want to increase position size.  And making a gradual change is justified. 

However, it's not a string of profitable trades that should be the determining factor.  The best approach is to demonstrate the ability to profit by making good decisions before considering the possibility of increasing size.  This does not mean three consecutive winners. 

It means several months of success – both in dollars earned and in terms of holding positions that do not involve more risk than you should be taking.  It may be difficult for the rookie to tell the difference between good luck and good trade management, but it's necessary to make that distinction.


If I'm making money, isn't that all there is?

Risk management is never considered from the same perspective as profits. Most traders who are able to earn profits – especially when they earn profits as soon as they begin trading – make the unwarranted assumption that they are talented traders.  They don't consider that the market may have behaved perfectly for their chosen strategy.

It's very important to understand the difference between trades that are well-managed and those that luckily end well.  This is a subtlety lost on too many.  The 'obvious' but inaccurate conclusion is often: 'If I made a profit then it was a good trade and I must have handled it well.'

To understand the risk of any given position (or portfolio), it's essential to know

  • How much can be lost, if the worst case scenario occurs
  • How much can be lost today, under unusual market conditions
  • What you have to gain by holding the position; i.e., potential profits
  • The probability of earning a profit from the position as it exists now
  • How theta (the passage of time) affects the position
  • The effect of a large change in implied volatility (vega risk)


To manage risk successfully, you must know

  • What is your first line of defense?
  • When will you take that defensive action?
  •     At some specific number of delta away from neutral?
        When your short option reaches a certain delta?
        When your position loses a specific sum?
        When you get nervous?
        When the risk graph tells you something specific
            Lose $X if the market moves another 2 or 3%?
            Lose X$X if one week passes or if IV drops by 10%?

  • What is your general plan when trouble looms?
  • Will you exit the entire trade?
  • Will you buy back a portion of the losing side?
  • Will you trade shares of the underlying asset to get delta neutral?
  • Will you buy extra options?  Which strike price?
  • Will you roll the position to farther OTM strikes?
  • If rolling, to which month do you plan to roll?  Same?  Next?
  • Do you plan to adjust in stages, or all at once?

As a rookie, you cannot be expected to have the knowledge or experience to prepare a plan with all this information.  But, you can pick a small number of items. 

I'd suggest that you know your first line of defense.  To me that means whether you plan to get out of the whole trade or plan to find a suitable adjustment.

The other important topic is when you will implement that line of defense.

That's a good start.  When you find it's time to make a position adjustment, the decisions you make may help you find another couple of items to add to your trading plan.

Over time, you will develop a sense of what you want to know in advance.  The better the plan, the better you can manage risk.

It's not essential to know these items in advance, but if you do, you will be in much better shape.  You can make decisions, when necessary, even when conditions are stressful.  Having a well thought out plan makes a big difference, especially when you lack the experience or discipline to make good decisions under pressure.  If you have never been short a bunch of puts in a rapidly falling market (with exploding implied volatility), then you cannot know how you will react.  It's far better to have a plan in place and then act on that plan when necessary.

As you gain more experience over the years, as you gain more confidence in your ability to react well under pressure, then these plans will be easier to compile.  If you prefer to make decisions on the fly, and are confident you can do that well (without emotions getting in the way), you can continue making trade plans with rough guidelines rather than specific trade ideas.

But don't give up making those trade plans.  It's good risk management to prepare for contingencies.

to be continued

675


Kindle edition

Lessons of a Lifetime


Lessons_Cover_final

, , , , ,

7 Responses to Short Course in Risk Management: Introduction

  1. Burt 04/30/2010 at 12:19 AM #

    Mark,
    This is a great post. I have written down your questions in my trade journal as a reminder for myself. One question: how would you go about quantifying “how much can be lost today under unusual market conditions”? Are you using your delta and gamma risk to quantify how a greater than a one standard deviation move would affect your position? Are there vega assumptions as well? Obviously, this question might be beyond the “rookie” criterion, but I think that question is one the best any trader can ask himself. Thanks!
    Burt

  2. Mark Wolfinger 04/30/2010 at 7:40 AM #

    Burt,
    Thank you.
    I’d use 2 or (better yet) 3 std deviations. 2 SD is an event that should occur, on average, once per month (5% of the time).
    Sure. On a down move, take a guess at IV. Maybe +10%. An an up move, maybe IV drops 3% (it could rise).
    This is an exercise to keep you aware of danger – we all know the calculation cannot be exact. But if your pre-determined maximum loss (that you are willing to accept) for a trade can be exceeded by such a one-day move, then you must be alert to that possibility.
    If the loss is egregious, trading smaller size may be a good idea. It’s a ballpark figure to give you a better idea of true risk.
    I use the risk graph, rather than doing the delta, gamma, vega calculations. A rookie should be aware of risk. Most traders cannot be bothered, or simply don’t know what to do. That’s a shame.

  3. Burt 04/30/2010 at 10:39 AM #

    Thanks very much. That was helpful.

  4. Burt 04/30/2010 at 11:48 AM #

    Mark, one point of clarification. When you say IV jumps 10% do you actual percent (e.g., 20% to 22%) or do you percentage points(e.g., 20% to 30%)? It just seems that on a 3 stdev day IV would go up more than 10%. Thanks again.
    Burt

  5. Burt 04/30/2010 at 11:50 AM #

    Sorry. I should have written do you MEAN actual percent or do you MEAN percentage points.
    Burt

  6. Mark Wolfinger 04/30/2010 at 12:28 PM #

    I did mean IV moving from 20 to 22.
    But keep in mind we saw a 30% jump not too many days ago. If your position is significantly short vega, then I would make the increase at least 20 to 25. Make ‘it’ a bad scenario to be sure you are not destroyed by the unexpected.
    It’s just a guess. We cannot know id advance whether there will be panic or complacency with a 3 SD move.
    The suggestion is help you get a feel for potential loss. If you trade a portfolio and your maximum acceptable loss is $5,000, you don’t want to hold positions that can lose $10,000 on a 3 SD move.
    This exercise is just one way to help you decide on the proper size to trade. Sometimes it’s difficult to know how many options or spreads is appropriate.
    Regards,

  7. Burt 04/30/2010 at 3:00 PM #

    Very helpful as always Mark. Thanks!