Risk Management - The key ingredient to your Options Investment success - Part l

Mr.Arete
May 22, 2022
9 min read

Introduction

When novices first sign up to learn boxing or martial arts, the very first intuition for them is learning how to punch or strike an opponent. They are in a rush to learn the offense because that brings them excitement. However, the trainer understands that if you cannot defend yourself from getting hit, then you will not be able to last long enough with the attacks from your opponent. So they focus on defensive techniques first -- how to block a punch, how to form a defensive stance, how to dodge a strike. Most novices fail to see the importance of defensive techniques. In sports, the motto is that defense win championships. You cannot win if you let your opponent score more points against you.

Similarly, in options trading, novices are quick to be enthusiastic about how much money they can potentially make - that is the most exciting part, and quite differently, most trainers or coach DON'T usually start by teaching them how to protect their portfolios from risks. You can have 10 winning trades, without risk management, your 11th trade can wipe off all gains from your 10 winning trades. This is a really important article for those serious enough to consider Options as a long term viable income generating strategy.

"Self-defense" (Risk Management) must be applied in option trading. There is a tendency to overlook the defense and focus a lot on offence, spending disproportionately more time on trading strategies and making money. We are not literally at the risk of getting punched in the face, but money under our care is under constant attack. It is a war zone. An arena. The Colosseum. We need to learn to defend our capital against other traders and investors we want to "take" our money... masked under the general word "losses". When we lose, essentially what it means is someone else has won and taken our money. We need to think like boxers; protecting our heads and bodies from attacks to our capital. Too many of such attacks will leave us with no money and therefore out of the trading / investing game. Again, as I have preached tirelessly from day 1 - Be a good Risk Manager first before jumping into the offense of making trades or establishing positions.

Many investors (myself included) have had the experience of making money on a series of trades only to see one or two bad trades wipe out all their hard-fought gains. Learning how to control and manage risk of each trade is therefore vital to the survival of your capital. Sadly, the one true way to understand the previous statement is through raw-hard experience. Only when you have gone through a period of tremendous returns and then be humbled back down by bad risk management will you truly understand the essence of the sentence. Or, if you're open-minded and wise enough, you learn from others' mistakes. But my experience has taught me that the best lessons are after getting a hard beating. Similarly, you think you are a good boxer until one day you actually get punched in the face.

We believe the difference between a good and bad investor comes down to proper use of trade and risk management. Stock picking, market timing, and analytical skills are equally as important; however it is risk management that allows investors to keep the fruits of their labor. We all have heard and seen many stories of day-trading "experts" in the tech boom in the 1990s where longing any company with "dot.com" on it makes money. More recently, the 2020 Covid 19 bubble which I had warned about in my previous blog article -- people walked in and longed stocks thinking that investing had always been so easy. However, most of these investors walked into the 2000s and 2021/2022 respectively with basically their gloves at their sides and were systematically knocked out one by one, many of them losing their stock gains, and over leveraging on options. These traders and investors focused on the techniques of trading without worrying about their downside.

Hence, anyone who is serious enough to embark on this journey must (not should) review the principles of good risk management. You need to study the principles and more importantly, apply them as you trade. As with any proper skill worth learning and retaining in the long term, you will not pick it up by simply reading this article. You need to constantly practice applying during your trades until it becomes second-nature, ingrained in your trading methodology -- so instinctive that each time before you click the execute button, your brain does a quick mental calculation of how many % of your portfolio this trade constitutes. Humans, being emotional creatures, are susceptible to stress, anxiety, excitement that comes each time a trade is executed. Risk management help remove the element of emotions from trading and helps you avoid making costly mistakes.

The Philosophy Of Risk

It takes money to make money. There must be something at stake before any potentially meaningful return can bear fruit. By putting your money at stake to make more money, you are bearing the risk of losing part or all of your capital in order to receive a reward. It is the incentive of the reward which encourages you to take on the risk. Because you must risk money in order to receive a reward, the science of finance is all about pricing and quantifying that risk to determine whether the reward is worth the risk.

Say, the 5-year US treasury note is paying a 5% interest per year. U.S treasuries are risk-free securities because the odds of the US government defaulting on the note is so infinitesimally small you are practically guaranteed to receive your interest payout throughout the life of the note, along with your principle at the end of the 5 years. Assume that a privately listed company is also offering a 5-year note at 5% interest per year. This is a very strong business entity. But there is still a small risk that the business can go bankrupt and you will not get your principle back, versus the US treasury note which is almost risk-free.

In this example, you will choose the 5-year US treasury note. Why? It makes no sense to purchase a riskier security that is paying the same interest and gives the same reward as a security which has technically no risk. There is no incentive at all to take on additional risk.

The basic concept or risk/reward is that you should be compensated for taking on additional risk by receiving a higher reward. That is why we have people who believe in things like growth investing - they invest in companies which have no net income now even though they have growing revenues, hoping that things turn around in the next 2-3 years and the stock price to increase disproportionately more than a normal stock. But they also take on more risk because a lot of these growth companies don't turn out profitable in the end and they end up losing almost all their capital.

Now, if the same corporation above told you they are offering an additional 3% of interest per year (bringing the total to 8%), then perhaps you might actually consider taking on that additional small risk of a strong business entity ending up bankrupt (unlikely) instead of going for the 5-year US treasury note. In other words, 8% per year is perceived by the market to be a sufficient reward to encourage investors to purchase that company's note.

This above example pretty much summarizes the basis of all investment decisions, whether stocks, options or any other securities. As we assume risk in our capital we want to know the reward we might receive. The way to select the best choice for our money when we are presented with alternatives is to compare the risk-reward ratio of each and find out which one gives a better reward for the amount of risk we have to assume. Therefore, before every trade, a good investor is always clear on how to quantify the risk-reward of the trade / investment.

In the context of Options, quantifying the risk-reward is straightforward once you start to do a few trades and understand the basics. This leads us to the next topic -- Key Principles of risk management.

Key Principle 1

Determine and quantify the max risk (loss) and max reward, breakeven points, before you enter a trade.

As shared earlier, a good risk manager has the instinctive ability to immediately calculate the potential risk of the trade, the potential rewards and the breakeven points. You should also strive to be at the level whereby you can immediately determine the max risk, max reward and breakeven points of any existing trades. Ingrain this in your mind and make it second nature. There is nothing worse than entering a trade blindly not knowing exactly how much the trade might mortally wound your portfolio.

Key Principle 2

You are a risk manager first. Then an investor or trader.

The frame of mind you should always adopt is "I am a risk manager". Interpret and think through how much you could lose. Once you have accepted that by entering the investment or trade, you are accepting that you could lose that amount of money, you can make a clearer decision on whether you are willing to proceed with the trade. Never let greed cloud your judgement and make you focus on your rewards first. This will lead to costly mistakes. For example, most people are sold on the idea of selling call / put options because they receive a premium and immediately take on a credit. They put their focus on how much money they can immediately receive and pay little to no attention to the enormous risk that comes along with selling naked options. Unfortunately, the moment they eventually learn would be the moment they suffer huge irreversible losses and are forced out of the game and have to restart all over.

You will begin to make decisions based on how to quantify, control, and limit your risk.

This is the Principle Arete has drilled into his members for the longest time. I caution readers to not take this lightly, because many years ago I was once an impatient option investor who eventually got humbled by the markets. Sticking by this principle has helped me to stay in the game for the longest time, even as I write this now in May'22 during the bear market.

Key Principle 3

Options are not a get rich quick scheme.

The potential returns of option trading are more significant, especially from an ROI perspective, but should in not way be seen as a vehicle solely for the purpose of getting rich quick. More often than not, if you chase riches quickly, you end up trading with more emotion, which leads to greed and emotions overwriting all your risk management principles. You usually become desperate, illogical, hopeful -- translating to you taking on additional risks or "chasing", leading to even larger losses. For the novices, having a stream of consecutive winning trades is a double edged sword. They develop a false sense of invincibility and ego and begin to increase stakes, only to see them fall more quickly since their method of achieving those returns are very risky and unsustainable in the first place. Better to aim for consistent returns monthly, letting those $100-$500 profits add up one by one, and trade with limited risk ensuring you have your skin in the game in the long run.

Key Principle 4

Investing is a marathon, not a sprint.

This sounds super cliché. Hear me out.

The honest truth I learnt about rewards is they take time and effort. Social media paints such an unrealistic expectation either showing everyone fake profits, or telling (scamming) people that they can turn $10,000 to $100,000 in 1 year. To me, investing in options is like running a business. At the start, if you don't get the right guidance, most of us lose money and it takes a hell lot of effort to learn, re-learn, research, digest, execute, document to even get some luck to produce decent results. Hence, the beginning stages are highly frustrating as you are more lost than ever and you don't immediately see results. This is normal, even for coders picking up coding, or software engineers, or data analysts, or financial analysts etc. We all go through the tough beginning phase and those who stick through it and continuously have the discipline, patience and determination to do the work eventually see the light at the end of the tunnel. The rest is history.

You should therefore have a realistic plan about how much rewards you can earn and in what type of time frame. This is also why I always tell novices who choose to join me - start with $3000-$5000, aim to make your first $30-$50 then slowly move up to $80-$100. Making $100 per trade now sounds extremely doable for me, but on hindsight, it was indeed a hurdle I had to overcome many years back when I first started.

Closing

I have listed down 4 Principles of Risk Management, and have more to contribute, which I will continue in my next blog post under Risk Management - The key ingredient to your Options Investment success - Part ll.