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?
- 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?
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%?
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.
Lessons of a Lifetime