Taking Risk

The following quote about risk taking is not as trivial as it seems. It’s an important concept. By Eric Falkenstein from his falkenblog.

Don’t expect to make more money for taking risk, just know you have to take risk to make more money. If you don’t understand the difference, you shouldn’t be taking risk.

I frequently discuss the fact that to earn higher rewards it’s necessary to either be a very skilled trader, or to take more risk. And I let it go with no further discussion. However, Eric points out the extra ingredient that was missing from any of my earlier discussions. The fact that extra risk is taken does not guarantee any extra reward. In fact there may be no reward.

It’s very possible for the given trader to be in over his/her head with more risk than the trader can handle. And the sad part about that is that it is not immediately obvious. A trader can adopt a new strategy or trading style successfully, without recognizing the extra risk. Until that day when the risk makes itself obvious and it is too late for the trader to recognize that he/she should have been prepared for the possibility that just occurred in the real world.

If you are going to take added risk, that risk must be understood. In many cases, a look at the greeks or a glimpse of the risk graph does not paint the whole picture.

As Eric says – you may want to make more money – and that usually requires taking additional risk But do not believe that simply trading riskier positions (such as trading bigger size) is the path to those profits. Often, that extra size creates situations that frighten the trader into panic mode because the amount of money at risk suddenly overwhelms the trader, if and when the unexpected occurs. Please don’t add risk to your trading before being certain that you are prepared to handle that risk. It’s acceptable to make a bit less money when you can do it without facing a situation that is psychologically too difficult.

The Risk Premium

Definition: The reward for holding a risky investment rather than one that is risk-free. Alternatively, it is the minimum anticipated return required to entice the investor to own the more risky position.

We all recognize that options trading involves some risk (the super-risk adverse, computer-assisted, traders can neutralize their positions efficiently). One problem is that it is difficult to describe the specific risk for a specific strategy. We can all calculate the maximum dollar risk, but because each of us makes risk-management decisions differently, the true risk is not something easy to measure.

Yet we must have some handle on risk to know whether it’s justifiable – considering the reward we want to earn. Options trading does offer substantial rewards. That’s the attractive part. It is well known that options are not risk free, and it is an individual decision on just how much risk to take. The problem is that many are unable to quantify risk.

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9 Responses to Taking Risk

  1. Don 06/10/2011 at 8:10 AM #

    Mark, I read this article and then purchased Jared’s book. You are right, it has good information much of what confirms your thoughts on trading…

    There is one section that I found surprising and worrisome…

    Motivated and numerate novice traders often observe that, after
    factoring in the risk/reward ratio and the probability of success of any
    given condor trade, repeating that trade over time will have a flat or
    even negative expectancy (after transaction costs). But that is not an
    argument against the viability of an iron condor spread or any other
    type of position. Rather, it is a practically tautologous description of
    locally efficient markets: Absent some viable edge or perceived advantage,
    there is no reason to expect that simply executing some type of
    financial transaction will generate profits.

    I have been spending a LOT of time on expectancy…Given the above how can we have some “viable edge or perceived advantage” that allows the trading of IC’s to have a positive expectancy?

    Thanks,
    Don

    • Mark D Wolfinger 06/10/2011 at 8:30 AM #

      Don,

      Good question.
      1) Jared’s statement is accurate, as far as it goes. There is no profit expectancy. However, there is long-term data that tells us that index options have been overvalued. In my opinion, when realized volatility is less than implied volatility, the trader gains an edge by selling that volatility. To collect that edge, we must hedge (manage risk).

      2) Jared’s statement refers to holding positions through expiration – because that is the period of time ‘studied’ by statistics. Positions from open through expiration would provide zero edge, if IV and realized volatility were equal. By allowing our judgment to enter the picture, by exiting when reward has become small, we cut exposure to a bad event. That’s more edge in our pockets.

      3) Position adjustment may lock in a loss. However, at other times, we made an adjustment that improves the position, increasing potential rewards while reducing potential (additional) losses. Another edge.

      Trading iron condors, or any other so-called ‘income-generating’ strategy is not free money. It takes work and skill. But the careful trader can have a small edge – big enough to make an excellent return on capital.

      • Don 06/10/2011 at 8:36 AM #

        Really good explanation! Thanks, it gives me hope! I have found some situations where IC’s are not the preferred method and that I have a choice to leave that trade alone or perhaps implement another strategy that manages a particular situation more effectively.

        • Mark D Wolfinger 06/10/2011 at 8:55 AM #

          Avoiding IC when the outlook does not look favorable is a good idea. However, it does require some ability in knowing when that is. When in doubt, stay out.

      • Don 06/10/2011 at 8:38 AM #

        Quick question does “realized volatility” = HV?

        • Mark D Wolfinger 06/10/2011 at 8:57 AM #

          Don,

          Yes.

          Realized volatility refers to the ‘actual’ volatility of the underlying asset. Thus, it is the historical volatility – over any given period of time. For indexes IV has been > HV (obviously on average, not every day)

  2. D. Hom 06/10/2011 at 2:33 PM #

    Don, the mathematics your broker uses to calculate probability of expiring in the money and expected profit automatically assume that your expected profit is the risk-free (that is, T-bill) rate of return. That is what is necessary to make the math work.

    Because of this, you have to recognize the limitations of the mathematical model. For example, it assumes that implied volatility is an accurate prediction of realized volatility between now and expiration. This, again, is necessary to calculate the probability of expiring in-the-money, and it’s also necessary because your broker’s software doesn’t know what the actual realized volatility is going to be. As Mark points out, IV is usually higher than realized volatility turns out to be, so selling options is a profitable strategy over time.

    Another problem with the math is that it assumes that returns follow a normal distribution (bell curve). Since returns don’t actually do this, there’s a lot you can do when you enter and exit your positions to adjust for this market inefficiency and actually improve your returns. The strategy tested in Jared’s book, the blind selling of iron condors, doesn’t take into account any methodology the trader should have used to get out of these condors when the edge was no longer present. That, combined with the fact that he’s using contracts with wide bid-ask spreads, makes it impressive that the iron condor strategy was even able to break even though an period like 2008. Given the high transaction costs of the strategy and the market crash that happened, one would have expected the strategy to lose money like the stock market did.

    I hope this is helpful. Please let me know if I can clarify or correct anything I’ve written.

    • Mark D Wolfinger 06/10/2011 at 3:13 PM #

      DH,

      Thanks for the contribution.

    • Don 06/10/2011 at 3:18 PM #

      @D.Hom Very nice explanation and helps with my overall understanding of expectancy! Thanks for taking the time to write about this!