I repeatedly write about the importance of risk management when trading options. Believe me when I tell you that I understand how much most of you are tired of reading about it. How can I know that? Because I've been in your shoes.
I firmly believe that if you don't pay much attention to what can go wrong and how much can be lost from a single position (or your entire portfolio), chances are very good that you will encounter an unexpected market move that will take your breath (and cash) away. If you survived the turmoils of 2008, congratulations. That builds confidence. If you are making money month after month with nary a problem, that builds over-confidence. Be alert.
One of the sad things about trying to help others become intelligent option traders is knowing what can happen when things go wrong. I remember my early years as a CBOE market maker. I found it very easy to make money. But sadly, I found just as easy to see it all go away.
Close friends warned me that my positions were too big and that I was asking for trouble. I was a constant visitor to my clearing firm's risk management office, but instead of heeding the warnings, I decided that I knew better. I was making good money, wasn't I? Surely I could take care of any problem before it overwhelmed me.
One day in 1984, one of the company vice president's took me aside and told me that my best friend and I were #1 and #2 on the list of risky accounts. I laughed it off with a comment similar to: 'It's just a computer searching for impossible situations that could make a big loss is possible. Forget it.'
To make a long story short, the clearing firm (First Options) unhappily allowed me to continue to carry the positions. It was just a few days later that my account was in deficit. I had lost it all. The explosive rally of August 1984 had done me in. I had been in trouble before, but nothing like this. I had to mortgage my condominium. I was frightened.
I dug in my heels, found trading capital, traded very conservatively and worked my way back. When the mortgage was repaid; when First Options had received every penny; I was greatly relieved. But that was an ordeal to remember.
I was finally convinced, but not cured. I still carried risk, but nothing similar to those early days on the trading floor. What's so sad is that I see it clearly now. There was more than enough money to be made and there was no need to remain naked short so many options. Today, I'm cured. No naked options for me (unless I want to buy a specific stock – which I probably will never want to do again), and all positions have limited risk.
That's the background. That's the reason I stress risk management. Just as I had to learn for myself, I'm sure some readers will find that they have to learn for themselves. I certainly hope it's a very small number of traders. I refused to listen to people whose business it was to understand risk and how to maintain it at a reasonable level. I'm offering you the same opportunity I had: to be made aware of risk before something terrible happens. I hope I'm getting through to you.