Short Course in Risk Management: Two Days. Part II

Part I

One risk management tool readily available to the individual investor is the risk graph supplied by your broker.  Those graphs provide a good overall snapshot of current risk.  Along with the profit/loss graph, specific risk parameters – as measured by 'the Greeks' are available.

The Greeks provide valuable information for measuring risk.  When the trader understand potential risk of a given position, it is easier to manage that risk.  However, the Greeks are not the focus of today's discussion.

Let's take a look at a hypothetical SPX (S&P 500 Index) position, assuming that it's Tuesday of expiration week.  As a reminder, SPX options are European style and stop trading when the market closes on Thursday (one day prior to the third Friday of the month).  The final, or settlement price for the index, is calculated, based on the Friday opening price for each individual stock in the index.

Ignoring how you came to hold this position, consider:

Position.  SPX price = 1205

Long 10 SPX May 1200 calls

Short 25 SPX May 1210 calls

Long 25 SPX May 1220 calls

 Let's assume that this is a single hedged position and that you have been managing risk on that basis. [It's always tempting to break a complex position into smaller parts and manage each separately. That's for each trader to decide.  For today, this is a single position]



This risk graph shows the P/L picture for the above SPX position.

The thin blue line represents risk as of today, with three trading days remaining before the options expire.  This graph looks pretty good.  If SPX declines, the loss is small, but if there's a rally, profits continuously increase as the index price moves higher.

The reason the position does so well on a rally is that the 10 extra calls (May 1200s) pick up value quickly.  The positive gamma translates into accelerating profits as SPX increases.

This position is not  all 'naked long.'  There's also the 25-lots of the short call spread (May 1210/1220) to consider.  These spreads lose value on a rally, but the gain from the 10 extra calls is enough to more than offset the loss from the 25 call spreads.

TWO days later

If you are still holding this position two days later, the risk picture has changed dramatically.  Thursday's risk graph is represented by the thick line (labeled 'think' line.  Although that's a typo, perhaps it shouldn't be).  At this point, both potential gains and potential losses are large.

Gains are essentially unlimited on the upside, but there is a barrier between you and those big gains.  If SPX settles (reminder, you will not know that settlement price until midway through the trading day on expiration Friday) in the vicinity of 1220, losses mount quickly.  The protection you owned on Tuesday has disappeared.

A rally places you in a big bind.  If the rally is BIG, you win.  If it stalls near 1220, you lose, BIG.  For most traders this is not a reasonable risk/reward scenario.  Everyone loves collecting theta as expiration nears, but that requires holding positions with negative gamma.  Thus, sometimes there's a big price to be paid to offset all those times when theta collection proves to be the winning choice.

This is too risky for me, but only you an decide whether it suits you and your comfort zone.   I urge you not to trade expiration week – at least not until you consider yourself to be experienced and able to handle risky positions with skill.  Closing your eyes and hoping they turn out well is not the skill set I have in mind.

The main point of this discussion is not taking today's risk graph at face value.  You must be aware of the effects of time an your overall risk.  A few days may seem insignificant – and it is when trading LEAPS options, but it plays a huge role when holding positions during expiration week.



"It is truly amazing how much I have
learned by reading your book.  I had shied away from trading options
because I thought they were too risky for a casual investor who did not have
formal training."


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