Tag Archives | money management

Adjustments and trading costs

A recent comment from Fran (from Spain), who writes an options blog in Spanish, raises an important point.  The obvious goal for traders is to make money and one sure-fire method for increasing profits is to reduce expenses. [This assumes that using a less expensive broker does not result in losing money via poor trade execution].

Some time ago I penned an article (free registration required) supporting the idea of reducing trading costs as a 'sure-thing investment.'

Fran's comments:

1) What about transaction costs with all these adjustments? The best adjustment strategy (in my opinion :-)) is to  reduce position size, because in the long run, transaction costs are another risk to manage and make a big difference in your trading performance.

2) if you have a verified trading edge, how does your adjustment bias affect this advantage? Have you tested it?

Hard questions to answer for a lot of options traders, but that trader must be sure that when cutting costs, edge is not being eroded. You must manage risk with low cost trades. Here, less is more

 ***

Fran,

I never object to size reduction as an adjustment. In fact, it is a method that should be used more frequently.  I believe there exists a trader mindset that equates exiting a trade, or even reducing position size, with doing something unacceptable: giving up and accepting a loss.  This is a loser's mindset because every successful trader understands the importance of limiting losses and exercising sound money management.

I know that winning traders recognize that it's impossible for each trade to be profitable. But more than that, they understand the importance of not fighting when the odds are not on their side.  Taking losses when necessary is an important aspect of the trading game.

On the other hand, I don't believe that size reduction should be an automatic decision.  It is often advisable (i.e., profitable) to adjust a position, rather than cut its size. 

Most traders consider 'being forced' to make an adjustment to be an unfortunate situation.  They miss the fact that adjustments can increase both the likelihood of earning a profit and the size of that profit. That is not something to be ignored.

Yes, transaction costs are important – and that's especially true for those who trade one and two-lots with a broker who tacks a 'per trade' fee onto the regular commissions. I have no idea how costly commissions are in Spain, but US traders can find good brokers with very low commissions.  Low enough to make them a very small consideration when making trade decisions.

 

Edge

I don't worry about 'edge' when making an adjustment.   I have only two concerns:

  • Does this adjusted trade give me a position I want to own? [I'm not likely to want to own it if I had to give up much edge to create it.]  Do I like the profit potential? 
  • Does this adjusted trade truly make the position less risky? Have I reduced the probability of losing money (from today into the future)? Is the amount at risk (both short-term and worst case scenario) acceptable?

If both sets of conditions are met, I pay the commissions and make the trade.

As to 'edge': I do not make a trade that I believe adds negative edge. I will not accept a position that is worse that it is right now (when an adjustment is needed). I prefer to take the loss and find a new, better position to own than to add negative edge to my current position.  However, 'edge' is not easy to measure because it depends on making an accurate forecast for future volatility of the underlying. In other words, our volatility forecast must be accurate before we can determine the value of the options, and the edge, we own in our posiitons.

Fran, Much of this is art vs. science. It's also a matter of personal comfort. Not every trader has yet learned the importance of being willing to accept a loss on a given trade.

Avoiding that loss can result in poor adjustment decisions.  Why?  The mindset that requires the trader to hold a position, also forces the trader into making almost any adjustment.  This is especially true when  rolling the position to a later expiration date,  with the hope of eventually earning a profit.  I have a friend who makes 'ugly' adjustments in preference to exiting the trade. 

Traders with that "I must do something to my position – but will not lock in a loss" mindset are not on the success path.  These traders would do much better to consider reducing or exiting a trade that has run into trouble

Thanks for the discussion

828

 

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Selling Straddles: Too Risky or the Best Income Generator?

Thanks for the blog Mark. It's just great.

I wonder if you can give some advice?

I sell straddles, usually 30-45 days prior to expiration on the SPX index at the current market price. What do you think is the best option strategy to offset large moves up/ down?

Say I sell an SPX Dec 1185 straddle on Monday Nov 1, collecting 60 points in premium. I feel that a large downside move may occur that could take prices 10% down from 1185. Would buying a straight put (or a put spread) be best? It's an expensive route to take and just wondering if you have another solution?

Thanks.

Zoe

***

Thanks.  Glad you find this blog to be useful.

The truth is that selling straddles is a strategy that seeks a high profit and it must come with significant risk

Zoe, when you are naked short options, loss is theoretically unlimited – and there's nothing to be done about that.  Sure, we know there will not be a 50% one-day rally, nor will there be a one-day 75% decline.  But they are theoretically possible and that makes it impossible to estimate the maximum loss for the straddle. 

If willing to live with the risk of a gigantic loss, then you may be comfortable selling straddles. However, because you are asking about risk reduction, I assume that unlimited loss is something you prefer to avoid.

Iron Condor vs. Straddle

The best (in my opinion) protection is to buy a put that is farther OTM than your short put.  In other words, I am willing to pay that very high price for the put because it provides complete protection against a huge gap opening – or any significant move.  By 'complete protection' I mean it establishes a maximum possible loss.  When you have the ability to set that loss potential, you are in position to trade more effectively.

 

Money management

For example, when you recognize the worst possible result, you are better able to size the trade properly.  Translation:  You can make a very good judgement about how many contracts to trade.  When selling straddles, there is no good method to allow effective money management. 

Note the difference: You can manage risk by adjusting positions as needed – assuming that there is no large market gap.  However, there is no way to practice sound money management money when you don't have a good  estimate of how much is at risk.

Yes, this is very expensive, reduces potential profits significantly and converts the straddle into an iron condor (assuming you do this on both the put and call sides).  However, it does allow you to have a better handle on money management and risk management.

Alternative: Strangle

If you fear, or anticipate a market decline, you can take out partial insurance right now – when initiating the position.  There is nothing magical about selling straddles, and you can trade a strangle instead.  In this scenario, you would sell the 1185 call, as planned, but could choose a lower strike put.  Perhaps the 1165 or the 1150 put?  The point is that you build in your market bias by making a small (not 100 points) adjustment in the strike prices of the options sold.

 

Protection

I've been trading options since 1975 and have come to one major risk management rule that suits my comfort zone.  I no longer sell any naked options (unless I want to buy stock and elect to sell a naked put in an attempt to buy stock at a lower price).  I have incurred too many large losses from being short far too many naked options – both calls and puts.  I am NOT telling you to adopt that same limitation.  What I am doing is asking you to consider the risk of selling straddles and decide if it works for you.  It may be a perfect (high risk) strategy for your trading style.

a) Buying debit spreads (puts in your example) is far less costly and provides far less protection than buying single options.  And that protection is limited. But if there is no huge gap, this is a very useful method to reduce risk. 

I'd prefer not to constantly use the phrase 'if there is no gap,' but the truth is, that's the big, ugly enemy for the naked call or put seller.  That gap eliminates the opportunity to make a timely adjustment before disaster occurs.

b) Another risk management method to consider is to reduce the time that you own the short straddle position.  True, the most rapid time decay comes near expiration, but if you take the extra risk associated with selling naked options, you can counter some of that risk by not holding into expiration.  Consider owning the position for only two or three weeks, taking the profit, and waiting patiently until it's time to open a new straddle.  Being out of the market is one sure method for reducing risk.

c) Other solutions exist, but buying single options or debit spreads represent the most simple and effective choices.

Another example is an OTM put backspread.  But please be warned:  The risk graph may look very good today and you may feel adequately protected today, but the passage of time turns these into situations in which you may incur a big loss from the original straddle plus another from the back spread.

Example

Buy some SPX Dec 1120 puts and sell fewer SPX Dec 1130 puts.  Because you own extra options, the gigantic downside move will not hurt.  However, if SPX declines and moves near 1120 as expiration arrives, this backspread can lose big money.

This is not the appropriate time to go into a further description of the backspread, but some of the problems are mentioned in this post.

824

 

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Iron Condors: Risk Management and Position Size

Mark,

My query relates back to your post on trading iron condors for a living which I found very informative. Without going over old ground, I am interested to know how traders who do choose to trade 100s of ICs each month on a single underlying manage the risk.

I ask because I found articles such as this one and also remember your having mentioned in the past that you traded much larger size. Any thoughts on this would be great.

Joe

***

This simple sounding question opens the doorway to a wider discussion.

When trading, choosing an appropriate position size is a crucial factor in the trader's ability to practice sound money management.  However, I don't believe size matters from the perspective relating to your question.  The requirement is that each trader use size that is appropriate for his/her account size, experience, track record etc.

If you trade 10x the size, adjustments would also be 10x larger.  You can easily make minor changes to achieve the desired result.  For example a 2-lot adjustment for a 10-lot position  may not be exactly 20-lots for a 100-lot position.  If its 18 or 23-lots, that's merely the effect of rounding.

Let's assume that a trader who has been using iron condors has opened a separate brokerage account that is used exclusively for trading iron condors, and that it has $20,000 in cash.   Important note: This is the amount that our trader is willing to place at risk for this strategy.  It is not his/her entire investment portfolio.

If we trade 10-point iron condors [The call spread is 10-points wide and the put spread is 10-points wide.  The distance between the calls and puts is not relevant], the margin requirment for each is $1,000 [although some brokers require $1,000 for each of the two spreads, and this practice may become more widespread].  The maximim position size for this account is twenty of these iron condors. [Some brokers allow customers to use the cash generated from the sale of iron condors to open more iron condors, but I believe this practice is being phased out].

Go all in?

Let's assume this trader frequently goes 'all in.'  That should not result in a portfolio of 20 iron condors.  It's essential to have cash available to make adjustments.  Adjustments are vital to your ability to prosper over the long term, and many traders (your reference for example) believe that adjustments add to profitability.

With this size account, I prefer to trade 16, or no more than 17 iron condors (and 14 to 15 is a lot more conservative), leaving $3,000 to $4,000 to meet margin requirements for some types of adjustmens.  Some adjustments require extra margin and some do not. Being prohibited from making necessary trades is equivalent to being placed in the penalty box and being forced to close positions (to generate margin room) or wait through expiration.  Most of the time when an adjustment is made, the entire iron condor is not involved.  The half iron condor that is at risk is frequently adjusted while the less risky portion is left as is – at least for the moment.

Don't allow that to happen.  Maintain enough free margin to provide freedom to trade.  Those readers who use portfolio margin instead of Reg T margin ($100,000 minimum account) should always have extra room.  If you use your entire margin allotment with portfolio margin, you are trading size that is far too big for your account.

More cash = more size?

Next, consider the trader with a $200,000 account.  If this trader wants to go all in I'd recommend doing approximately the same thing, but 10 x larger.  Keep in mind that if this trader feels that $200,000 devoted to iron condors is too much, then cash could be transferred to another account.

So to me, size trading depends on more than counting the number of contracts traded. If you have the ability to fund the account, are comfortable trading 160 iron condors simultaneously, don't feel uncomfortable with the money at risk, and have a successful track record of trading iron condors, then this is appropriate size for $200,000 account holders.

Joe, I don't believe there is any true difference.  When the trader can comfortably handle the size traded, and meets the criteria mentioned above, the risk is not too difficult to handle.  The smaller trader's $2,000 risk is the bigger guy's $20,000 risk, but each should feel about the same pressure when that amount is on the line.  The only warning I would give to the larger trader is to be certain that the underlying has enough liquidity to handle his orders. 

It's not enough to say that RUT is very liquid.   I have discovered that OTM 3-4 month options have far less liquidity [I've had several instances for which I was able to buy only one-lot of 3-4 month RUT iron condors.], and would not be comfortable trying to trade 100-lots of a RUT December iron condor today – unless I were willing to trade closer to the money options or accept a less than desired credit.

Worth repeating

I would NOT advise a person with a one million dollar account who is first learning about options to place significant money at risk.  That is true for any rookie.

I'd recommend using no more than $25,000.  In fact, I'd suggest paper-trading to give the new trader some much needed practice.

Joe, once you decided that trading $X is appropriate, and as long as the underlying has the liquidity needed, and if you adhere to the guidelines above, position size should automatically be at an acceptable level. The larger trader is not at a disadvantage.

Extra note:  I have some disagreement with the advice offered in the article that you referred to above.  The major one is this statement: "Condor manage­ment requires adding size when rolling."   Adding size is increasing risk, and is only appropriate under certain conditions.  That's a topic for another time.

800

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Options Trading: The Role of Luck

Bad Money Advice is a worthy blog.  Penned by "Francis X. Curmudgeon, the alter ego of a bitterly unemployed hedge fund manager in the suburbs of Boston, Massachusetts," the blog is designed to publicize the fact that so much bad advice is readily available that he feels the need to combat it.  In his words,

"the main topic here is the advice given by others and how bad it is. And
not just any advice. I mean to talk about advice on a single subject of
almost universal interest: money."

In a recent post, he discussed the role that luck has when investing.  Most traders have a great deal of confidence in their ability to outperform the markets, but the unsophisticated retail investor must play the cards dealt. 

"Consider somebody born in 1916 who turned 65 and retired in 1981. In
the 20 years before his retirement the stock market averaged a return of
only 6.57%, just 1.07% ahead of inflation over the same period.
$100,000 invested in the market on his 45th birthday would have been
worth $357,026 at 65.

Now consider someone born 17 years later, in 1933. Over the 20 years
before his retirement in 1998 the market averaged 17.32% a year. (That
happened to be its best 20 year period since 1890.) $100,000 invested on
the last day of 1978 would have grown to $2,440,288.

The difference between $357K and $2.4M is tremendous in terms of
retirement wealth and lifestyle. And yet all that separates these two
people is the year in which they were born. And those years are not even
that far apart. The 20 year investment periods actually overlap."


As traders, we don't rely on the cards dealt to us.  In fact, we are constantly reshuffling the deck.  Nevertheless, any time you deal with probability, statistics must be considered. 

Whether we buy or sell options, we undertake a trade that is based on probability.  Over the longer term, chances are high that statistical predictions will be validated and that a 70% probability event will occur roughly 700 times out of 1,000 events. [Reminder: unlikely events, or the tails of the probability distribution curve, appear far more frequently than predicted].  However, on a single trade, luck plays a role. Or as one definition of the term provided by Wikipedia:
"luck is probability taken personally."

Unless you want to depend on having good luck – a very poor investment strategy – it's important to take matters into your own hands.  That's why it's so smart to practice good money management (size trades properly) and good risk management (control losses). 

As regular readers know, risk management is a constantly recurring theme at Options for Rookies.  Unless you have very good luck, trading without a proper respect for risk, and constantly being aware of and managing risk, there is little chance you can succeed as a trader.  It's a difficult enough profession without taking more risk than is prudent.

Risk management is vital for survival – even when you trade/invest without being a professional.  I wonder if Francis X agrees.  I trust he does.

763

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Money Management

Here is a good, basic definition of the term ‘money management’ from Wikipedia:

Money management deals with the question of how much risk a decision maker should take in situations where uncertainty is present.

More precisely what percentage or what part of the decision maker's wealth should be put at risk in order to maximize the decision maker's potential.

Money management is a necessity for gamblers and traders. A good understanding of money management minimizes the Risk of Ruin, or the possibility of losing your entire trading account.

The two keys to successful money management are maximizing wins and minimizing losses.
Thus, the takeaway for us, as option traders is:


  • Trade size is a very important decision (how much to place at risk)
  • Minimizing losses is essential (do not stubbornly allow losses to grow)

  • Maximizing gains is a big part of the game (but do not ignore risk when seeking that maximum)

This last part – about maximizing gains for every winning trade – presents the trader with difficult decisions. To maximize profits, you must milk the trade for every last penny. But that's in direct contradiction with the concept of not owning positions when there is very little to gain and risk is large (very poor risk/reward ratio).

Assume a position with limited profit potential has worked well. Perhaps you sold a call or put spread and collected $1.50. When you earn $1.40 and can repurchase that spread by paying $0.10, you come face to face with good money management and careful risk management may appear to be in conflict.

When managing risk, both potential loss and the probability of incurring any loss must be taken into consideration.  When deciding whether to exit a wining trade with limited potential profit, can you afford to take the risk associated with going after the last $10? 
Obviously time to expiration and how far OTM the options are must be considered. However, I’m from the conservative school that believes it cannot be a sound policy to hold this position in an attempt to earn another $5 or $10 per spread.  The risk manager and money manager must come to an agreement.

The idea of trying to maximize profits may lead you to assume that it's always correct to seek that last nickel and allow all short options to expire worthless. That's not a valid assumption.

The term 'maximize profits' does not tell you to ignore risk. It refers to the concept of seeking additional profits from good positions – and that's a position is worth holding. Often risk is too large, reward is too small, and the best decision is to exit.

The definition of money management does leave room for debate on this point.
If you believe that being too cautious is unwise, and if your comfort zone allows trying to capture additional profits, I cannot argue. The borders of your individual comfort zone are yours to define. My task is to encourage you to define that zone and to recognize that it is not a lifetime commitment. Borders can and will shift over time.

I'll continue to pay a small price to exit the trade. Peace of mind has psychological value, and I'm willing to pay a small insurance premium to gain that tranquility.

735


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Risk Management and Position Size


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***

Hi Mark,

How do you determine position size ? What can someone use to guide
them to determine lot size, contracts traded etc ?

Dave

***

Hi Dave,

Obviously, a good question and one that I never addressed.  I'll offer some guidelines and an example.  As you may suspect, this is a guide and not a method for deciding exactly how many contracts to trade.

1a) At the top of the list : The trader must be comfortable with the largest possible loss for each position.  If a position involves being naked short calls, then that 'maximum' must be estimated. 

This is just as true for premium buyers as for premium sellers.  Buyers cannot get wiped out overnight, but they do get wiped out by paying prices that are too high or holding positions too long.

1b) A more realistic reply is that the trader must be able to withstand the largest likely loss.  This is true not only for each position, but it must be true for the entire portfolio (this is the part many traders ignore).  If you have five positions and each passes the test, be certain that if all five were to move against you at the same time that you would survive.

1c) By 'survive' – I do not mean 'barely survive.'  It means that the loss from a single position can be shrugged off as the cost of doing business.  It also means that the drawdown from a total disaster (losing the maximum from all positions at once) does not eliminate your ability to continue trading.  Risk of ruin must not be ignored.

The above response does not answer your question

Here are more General Guidelines.

1) Determine how much money you want to devote to trading options.  If possible open a separate account to house that money.  If you do any covered call writing, then obviously this account must include your stock holdings.

If you keep your entire investing assets in a single account, then it is difficult to see how much margin is tied up with option positions.  When there is extra cash (or margin availability) lying around – it's tempting to use it.  Thus, a separate account (surely your broker will accommodate your request for a sub-account or a separate account) makes it much easier to track option P/L and risk.

2) If you do as suggested, then 100% of that account is devoted to options trading.

3) If you choose to accept portfolio margin (many brokers require 100k minimum for this) you have the room to trade many more contracts and much greater size.

If you choose (or must accept) Reg T margin, then you are more limited.  However, that's not a bad thing because you are ultimately safer.

In my opinion, Reg T margin is best for the vast majority.  If you have proven to yourself that you can handle larger positions, if you trust your risk management skills, then you can opt for portfolio margin – if eligible.  But please know this:  With Reg T margin, positions are limited and you cannot go into deficit. That is not true with portfolio margin.  Obviously your broker will limit risk because if your account goes into deficit, the broker is at risk that the customer will not be able to repay.

4) Never use all available Reg T margin.  Allow at least 15% for emergency needs – such as making adjustments that increase margin.  There's no room to discuss here, but not all risk-reducing trades decrease margin requirements.

5) Dave, if you have a small account, trade small.  With a $10,000 account, you don't want to trade more than three or four credit spreads, or iron condors at one time.  A loss of $2,000 would not put you out of business, but it would be a significant loss.  And it's easy to lose far more than that with a 4-lot, 10-point iron condor.

6) When you begin trading, it's not so easy to recognize an acceptable position size.  Paper trading can be very useful in this regard.  When you experience the profit and loss per spread, you can get a feel for what would be at stake when trading live.

7) Truths

  • Most
    people who begin trading are optimistic.  They do not think in terms of
    losses, but instead, concentrate only on how much money they can earn

  • It's virtually impossible to find a reasonable position size when the trader does not consider scenarios in which money is lost
  • If you accept the premise that limiting risk is essential to becoming a successful trader, then sizing trades is easier.  If neglecting risk, selecting position size is merely a guess


Assume you trade a specific strategy with limited losses.  Further assume that you have the discipline to exit the trade when your loss reaches a certain level.  This loss level does not have to be written in stone, but it's a reasonable approximation. 

If those assumptions are valid, then you can establish an appropriate position size. 

Next, decide the maximum dollar loss per trade. Assume your position goes awry and you
lose 10% above that maximum loss. 

That's it.  That tells you how many spreads you can afford to hold at one time.  Obviously of you find a trade situation that feels better than normal, you can increase size by a modest amount.  When markets are more uncomfortable for you to trade, enter with smaller size.  You can always add to a position later.

Example:

Assume: (Please recognize that approximations are made)

a) You, Dave, prefer to sell credit spreads.  Calls/puts or both (iron condors)

b) Your minimum premium requirement is to collect $1 for a 5-point spread. (20% of the maximum value)

c) Your account is valued at $100,000

d) You plan to carry at least 10 such positions at one time (that's a large number, but let's go there for now)

e) You are psychologically and financially able to accept a loss of $5,000 from any one position

f) You have the discipline to exit a trade (ignore adjustments for this discussion) when the loss is $150 per spread [This is a randomly chosen number; it is NOT a recommendation]

g) You must limit portfolio losses to $20k at all costs.  This is the bottom line for you.[Again, a random number]


Based on those assumptions, what can you trade?

If you trade a 5-lot of each, and if you only collect your minimum of $100 per spread, then you sell 50 spreads (5 x 10 positions) and collect $5,000.  If there are any iron condors in this portfolio, you collect an extra $100 for each of those (you collect on both puts and calls).  The maximum possible loss is $400 per spread, or $20,000.

And that's the worst case.  You plan to exit when losses reach $150 per spread,  If that happened to all 50-lots simultaneously, you would lose 50 x $150, or $7,500.  Allowing for a loss that's 10% above the maximum (poor execution of orders, or delay on your part), moves the loss to $8,200.

If some positions are calls and some are puts, you would not lose that much.  

Thus, it's reasonable to trade about 2.5 x as much, moving the maximum loss to that $20,000 level.  This is a very unlikely outcome and with this scenario, I'd suggest that you could afford to trade as many as 12 to 13-lots of ten different (5-point) credit spreads. 

We all know that that is too many positions to manage effectively,  but you can afford to trade a reasonable number of contracts.

If you trade only one position, you can trade the same 60-lots.  And if selling 10-point spreads at $200, then 30-lots should be okay.  Trading this much size would present no problems as far as margin is concerned. [Margin requirement is 30k, less cash collected, on 30, 10-point spreads).

Dave, this is approximate, but I don't know how to decide how much size is appropriate to trade without going through an exercise such as this.

'This above all, to thine own self be true."  That means – DO NOT move beyond your comfort zone.  Trading less size is just fine.  It's trading more than your  size limit that must be avoided.

722


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