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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


Kindle edition

Lessons of a Lifetime


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Adjustment Headaches

Hi Mark,

Recently I have some mixed feelings about iron condors (IC), and hope to
benefit by sharing my thoughts here (and hopefully you have some input that
may enlighten me and others who trade IC).

While veterans like you have
mentioned that IC is not a free lunch, I think I have a way to put this
in context. Although IC adjustments are a must for long term success, I
believe these adjustments only make deferred losses (aka preventing an
immediate loss).

If all the positions are closed immediately after
adjustments, then it results in an immediate loss. The
deferred losses pile up as more adjustments are made.

adjustments are made, then the IC trader hopes that the market will
treat him kindly so that theta decay is accumulated by enough to cover the
deferred loss, and hopefully have some left as profit.

But hope is
not a strategy, as you have said.
So my conclusions are:

  • IC does not have a clear advantage compared to other strategies
  • The only feature that makes IC look promising in hindsight is
    the upfront collection of premium

Mark, I wonder you agree with my point of view.



1) I do agree with your point that IC do not have a clear advantage 

But there is zero advantage to collecting cash upfront, unless that gives you a psychological boost.  An equivalent strategy requires the payment of cash upfront, but the result is the same.  If that cash is the main reason that you trade IC, I strongly suggest that you reconsider, and perhaps find a strategy that is better suited to your trading talents.

2) I don't believe any strategy has a 'clear advantage' over most other strategies.  Some methods work better than others for a given trader because the trader is better equipped to manage the position

a) I believe the 'strategy' tells you which options to buy and sell as your ticket onto the playing field.  You can play the 'options trading/investing' game with a variety of strategies

b) Once you open a position, you are on that playing field. At that time, risk management takes over as the vital factor that determines your eventual success (or not)

5) I don't know how you choose to adjust your IC positions, and that information is not important.  But it's clear that whatever method you are using, it is not working for you

Here is what is important:  AFTER you make the adjustment, do you believe you have a good position?  (If the answer is not 'YES'! then you do not want to make this adjustment) Good being defined as:

a) You expect (not hope) to make money with the position as it is RIGHT NOW.  Not compared with the original price you received when opening the trade.

b) If you have a market bias, then you anticipate a profit when that bias becomes reality.  Neutrality is a market bias

c) If you don't believe the position will be profitable going forward, don't own it.  That means don't adjust the original trade.  Close the position

Adjusting a position is truly the same as opening a new trade.  The major requirement is that the trade is suitable for you.  The one advantage to adjustment is that you save a bit of money on commissions, but that should never be a factor.  If commissions are too high, find another broker.

d) If you look at adjusting as deferring losses, then I don't believe you are making good trades.  Adjustments can be profit centers – they are not only used to 'defer losses.'

Here's an excerpt from an earlier post:

'The bottom
line is that when you make a trade to adjust the position, it's going to
improve what you currently own.  That's why it tends to be a money
maker going forward.  No guarantee.  But you had no guarantee when you
initiated the iron condor in the first place.'

e) My view on adjustments is this

i) The new position is good, meets your criteria for profit and loss potential and fits snugly (with room to spare) within your comfort zone

ii) If EACH of those characteristics is not present, then DO NOT ADJUST.  DO not own this position.  EXIT

iii) Sit on the sidelines or re-invest your money in a fresh position

iv) Adjustments are not made to defer losses.  They are made to give you a good position.  Not a reasonable position, not a position you 'don't mind' holding.  NOPE.  A good position.

v) You have a choice:  Exit and open a new, good position.  Or adjust.  Why adjust if it's not something you WANT to be part of your portfolio?  Why defer a loss and keep a bad trade?  Don't do it.

6) Bottom Line:  Don't think of it as an adjustment.  Mentally think of it as a two-step process.

a) Exit

b) Re-open the adjusted trade

If you would not do b) after doing a), then don't adjust.  If you don't want to own b), then don't own it.

I understand that you may feel this is too simplistic and that it does not truly provide the guidance you seek. The truth is that there is no 'best' answer.  I suggest you do two things, both realistic:

1) Look for alternative adjustment methods

2) Adjust earlier, perhaps in stages


The second issue of Expiring Monthly is coming soon: Monday Apr 19, 2010


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