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Risk Management: First Line of Defense. Part III

These trades are not always winners

As we were discussing before the time out,
stocks can fall and losses can accrue when you adopt covered call
writing as a strategy. (Stating the obvious to be certain no one misunderstands: All strategies can lose money)

If
the stock price decline is severe, two unpleasant things happen to your
position.  First, the option has become relatively inexpensive and affords
essentially zero additional downside protection.  If the stock price continues to
fall, you lose money at the same rate as any other stockholder.  The trader who believes in managing risk does not sit idly by and watch money disappear from the trading account.  Yes, there's always the chance that the stock reverses direction and money flows into the trading account.  But hoping for that to happen turns this option strategy into a gamble.

Assuming you don't want to gamble, select a stock price that represents your limit.  This is similar to a stop-loss order.  When the stock reaches your price, you already know that you will take some action.  This is one of those decisions that can be planned in advance. 

Knowing when to take action to hedge against additional losses is not an easy decision for the inexperienced trader – but it is necessary to learn that skill.  However, in the early learning stages of becoming a trader, the objective is to choose an appropriate trade that satisfies your needs to reduce risk to an acceptable level, and allow for a profit (going forward).  As you gain experience, you will learn which trades are best suited for your personal trading requirements. 

Good record keeping helps a trader to become better.  However, the concept of keeping a trade journal is a very lengthy discussion on it own.  It helps with risk management because it gives you an opportunity to see which previous ideas worked.  This series would never end if I included my thoughts on keeping a journal.

Now that you know when (in terms of stock price, not in terms of the calendar) you plan to take action to reduce risk, the next task is to consider some specific trade ideas that will accomplish two things.  First, risk must be reduced to an acceptable level going forward.  Second, the position must suit your comfort zone.  In other words, you must want to have that adjusted position in your portfolio.

When no suitable trade can be found, it's best to exit and take the loss.  Choosing which action to take as an adjustment is discussed later.


When to adjust

Knowing that your call premium protects you down to $23.50 (at
expiration) helps with the decision. 

NOTE:
Prior to expiration protection decreases (i.e. the break-even point is higher than $23.50.  Why?  Because that call option has
not yet reached a price of zero.  If you decide to take action to
reduce or eliminate risk, you must buy back the call sold earlier. The rationale for doing that is simple:  If you sell another call option to bring home more cash premium, you would still be short that original call.

Most brokers do not allow any traders to be short calls that are not covered by stock, but that's especially true for the inexperienced trader.  Although it only causes problems on occasion, it just' too risky to hold that short call with no protection.  Sudden good news can result in a price surge.  Being short a naked call is not prudent and a good risk manager knows not to do that very often (if at all).

When you buy back that call option, it will not be expensive, and it will feel as if it's a waste of money.  Nevertheless, if you decide to sell a different call option before expiration, you must repurchase that call.

Managing risk involves different techniques and different ways of thinking.  It's impossible to delve into specific risk management methods for each strategy.  My plan here is to make you aware of the need to do something, perhaps make a suggestion (such as buy back that call and sell another), but the emphasis of this discussion cannot be on specific remedies for every strategy.  Because I'm using covered call writing as an example, sample trades for that method will be included.


Assume that seeing the stock
touch 22.99 is the right time to reduce risk, then as that stock price
approaches, you have to be ready to do something.  When making the plan,
determine if 22.99 is a 'hard stop.'  if it is, then you will take
action and not bother to worry about changing that price.  If it's a
'soft' stop, then you must know – again in advance – just how much
leeway you are going to allow before taking action.  The best leeway is
probably zero.

As you
gain experience, gain confidence, and make money, DO NOT abandon these
guidelines that helped you get where you are.  It's okay to become a bit
flexible, but there's a big difference between being flexible and being
stubborn.  You cannot afford to adopt the loser's policy of refusing to
accept a loss.  The truth about trading and investing is that losing
money on some trades is inevitable.


The
Plan

Question:  How
far can this stock decline before you become
afraid of losing more than you can afford to lose?  Or to be less
dramatic, more than you are willing to lose?  In this example that price
is $22.99.

NOTE:
When writing covered calls it's usually easiest to choose a stock price
as the trigger for taking action to reduce risk.  But there are other
strategies, and other means are often used to make the decision.  Some
of these triggers:

Position delta.  Are you too long or too short for comfort?

Position gamma? Is the delta changing too
quickly?

Dollars lost? 
It's best to set a maximum loss per trade.

Something different?  Perhaps technical
analysis.  Perhaps you changed your market view on the underlying stock.  Any rationale you for adjusting that you believe is worthwhile – is worthwhile.


Please understand that this is an example, and I
am not recommending a specific price. There is no correct price
because each trader has his/her individual risk tolerance and stock
market outlook.  But let's assume that price for you is $22.99 per
share. 

You now have
the answer to the second of the two questions posed earlier.  You will
'take action' when
the stock price reaches, or approaches $22.99 per share.  Above that
price
you are willing to hold the position.

It's necessary to answer the other question: 
What action will you take?

to
be continued…

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