Risk Management - The key ingredient to your Options Investment success - Part ll
- Mr.Arete
- May 27, 2022
- 7 min read
Updated: Jun 3, 2022
Risk
The whole point of using options to trade is - they are an excellent tool for limiting and controlling risk. There's no better tool. You can literally define your parameters, install your own guard rails, set boundaries. Therefore, your first step is to always trade with the intent to limit or control your risk, because that is something which you have control. Doing so will significantly reduce the possibility of losing a huge chunk of your capital from one bad trade.
Once you have identified what your max risk is, the next step is to determine what your plan is if the trade goes against you. It is nice to think or believe that every position you enter into will make money, but you always have to consider what will happen if you are wrong. You need an exit strategy based on the price of the underlying stock or the percentage loss at which you decide to close out the position to prevent any further loss.
This is a continuation of Part l.
Key Principle 5
Determine your exit strategy for when the trade goes against you.
Develop an exit strategy ahead of time, then you can focus on executing the decision or exit plan before your money is in greater risk. Instead of wasting time dwelling on what to do, you can make a clear, emotionless decision regarding how much you are willing to absorb before you decide to close the position. If you wait until the stock starts to go against you even more to a point a no return, you may panic, get frustrated, paralyzed, and fail to pull the trigger and close the trade when you should / could.
You may even utter the phrase which is the kiss of death to risk management: "This stock cannot keep falling. It has to recover and move back higher for sure!".
At any point in time as soon as you mention this phrase (verbally or consciously in your brain), you are practically letting your trade control you. You live on the false hope that the trade will recover. So you usually end up waiting and doing nothing and losing even more money.
Remember, no matter how low the price of a stock drops, the stock has no obligation to move back higher simply because you hold a position on it. Such thinking will violate the next principle...
Key Principle 6
Only Mr Market knows which way the stock is moving, you cannot tell him where you want the stock to move.
Each week you should read the news, understand what is happening in the world, notice the obvious signs and leading indicators. If the market is telling you that the general direction is headed south, you best trust the market signals. Especially important when you already hold existing bullish positions; your perception is skewed and biased because you are losing money and you will start to look for non-existent bullish signs which are not there. You will catch onto any faint signals of bullish news (which are obviously false signals) because you are so desperate for the stock to recover.
Hence, it is important to pre-plan your exit plan and stick to it, close the position if you have to. While having a plan is important, it will only work if your follow the next principle:
Key Principle 7
You should have the willpower and discipline to stick to you exit strategy plan to cut losses no matter what happens. Any decision to stray away should be based on sound analysis or a result in a change in circumstances of the underlying security.
Your exit strategy is based on your personal risk tolerance. It is better to establish a specific exit strategy than a generic one. For example, let's assume you did purchase 100 shares of $BABA at $70. You could have decided to close out your position if it loses 15%. You could have used a monetary value and decided to close out the trade if it is down by more than $1,000. If you used technical analysis(which is a skillset I strong encourage you to pick up), you may have developed an exit strategy based on the stock price and a technical indicator you found in the price chart for $BABA. For example, if you found a key level of support at $65, you could have decided that you will close out the bullish position if $BABA breaks through support at $65 and continues to move lower.
After such a long period of time experimenting, trying and back-testing here's the finding: there is NO one right answer in developing an exit strategy. Each person has a different risk tolerance or different assumption of where the stock will move to. Therefore, it is recommended that you develop an exit strategy that is comfortable for you. For me, I set a max of 3% of my capital in any one single trade. This works best for me.
If you put $5,000 of your $200,000 portfolio into $BABA, you may be willing to absorb more of a loss before closing the position than someone who has the same $5,000 worth of $BABA in a, say, $10,000 portfolio. Comfort is key here. As long as you are comfortable with your risk exposure and portfolio allocation, and therefore risk per trade, your only real concern is that you stick to your plan and act immediately when the stock hits your loss target, whether a specific stock price, loss percentage, or loss amount.
This approach is also applicable to trading options, because the underlying security is a stock. For example, if we bought a $70 call on $BABA instead of 100 shares of the stock, we could use the same criteria for determining when to close out our option position, with on notable exception -- Time. Because options have expiration dates, time affects the value of our long options as well as short options.
Therefore, we may also have an exit strategy based on time. For example, we may expect $BABA to move higher in the next 30 days or so and purchase a 3-month call option. Our exit strategy could be that we close the long call if $BABA has not moved higher in 30 days because that was the time period in which we expected the move.
Risk management is first determining what our maximum risk is before entering a position and then developing an exit strategy to close out the position if the trade moves against us. You will never have a perfect record when trading; you will have losing positions no matter what you do. But... if you have 10 trades and 9 move against you, you can still have an overall positive return if you practice good risk management by closing out the 9 losing trades before they produce significant losses. Always know the full risk before doing any trade and always have a plan to get out if you start to lose money.
Key Principle 8
Have an exit strategy for closing out your profitable positions.
The most common misconception is "if I am making money in my trade, why do I need an exit strategy?"
Failure to have some sort of profitable exit strategy usually indicates that you do not have a vision going into the trade. You expect the stock or option price to go up and make money, except that stock or option do not just go up indefinitely. Knowing the best time to get out is also important. What usually happens is that you end up cutting profits short or letting winners run too long until they reverse and produce losses.
Therefore you need to manage your gains as you manage your losses.
Before entering a trade you need to develop a plan as to what your profit target is. Keep things simple: once the profit target is reached you should close our the trade and pocket your returns. You can afford to be less strict with profit taking because the profit provides additional room to breathe. You can give the position more time as long as the stock or option continues to show strength in moving in the expected direction.
For example, you can choose to close out the option trade if it is making 30% or if the stock hit a certain price point or resistance point. Another viable option is to close out half your position when the trade doubles in value to take your cost off the table and play with "house money".
What this means is, say you bought 2 x call option for $200 each and the option value is now worth $400 each after a stock price increase. You can sell away 1 x call option away and profit $200, and let the other call option run, with the worse case scenario of you losing nothing because the if the second call option becomes worthless, the maximum you lose in that second option is $200, and this $200 is something you already made previously and realized the profit.
In addition to an exit strategy, if you get more advanced, you should also plan potential trade adjustments to enhance the performance of your position. Trading adjustments something which you can do once you have attained a level of expertise in options; they are meant to reduce your risk, lock in a profit, or hedge against a loss. Making plans on how to adjust a trade while in the middle of a trade could lead to a rushed decision that is not well thought out. It is best to have an idea of what potential adjustments you can make prior to the trade. However, to know what types of adjustments out there requires experience in options trading because you need to develop that foresight to see forward different scenarios playing out and be already familiar with the adjustment you could make for each scenario.
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