Trading options is risky business. It stands to reason then, that all good option traders are first risk managers. As I've said before, my main objective is to manage the losses and the risk. The profits seem to come from the best risk management I can muster. Letting a condor or vertical spread slip away from you can easily eat up a month (or months) of profits.
With that in mind, I have some risk management ideas that I try to use in order to minimize significant losses. The first guideline is that I have a 2% risk limit for every trade. In short, that simply means that I don't like to put more than 2% of my total account value at risk on any one trade. At the same time I want to put as much capital to work as possible; so I have to think of ways to capitalize many trades and diversify them in such a way that I don't fall prey to deeply correlated trades.
Correlation risk is one of the great challenges when trading equities, whether options or stocks. Markets seem to move together, even when it doesn't make sense. Particularly lately, the market seems to drag everything down regardless of sector or market. It's impossible to avoid risk altogether, and if it were no one would want to pay us for assuming it. My objective then, is simply to minimize risk through diversification, which I primarily consume in three flavors:
- Time Diversification: When I take on trades of any size I begin by spreading my capital across time. In other words, I slowly scale into the trade. With condors, for example, I usually start about 49 days out, then add another condor at the 42 day mark (or so), and possibly more at 35-38 days. As you may remember from my ongoing condor trades, this also happens in conjunction with technical analysis, but the main point is that it doesn't all go on at one time. This accomplishes one of two things. First, it allows me to spread my trades across a wider range of strike prices. Second, if things don't move much I may not get the strike prices much wider, but I can add to my position with some confirmation of a fairly steady market.
- Underlying Diversification: Diversification on the underlying is another way I've been spreading risk. For example, I frequently use RUT for equities, as you've seen in my condor trades. But I also use OIH (or others) for oil. In recent months oil seems to be moving along with the market, but it hasn't always been that way (nor do I think it always will be). In fact, for a long time it was rising oil that was blamed for a falling stock market. At times I may also use other ETFs or Indices to represent agriculture, gold, or other commodities.
- Strategy Diversification: The final type of diversification that I try to use is a variety of strategy. Vertical spreads (including condors and butterflies), horizontal spreads, diagonals and stocks all have their own unique characteristics. They often balance one another to minimize risk in price and volatility.
- Trend Risk: While this isn't a type of diversification, it's worth noting that one of the ways we minimize risk is to pay attention to the trend. I was talking to a friend just today who is desperately looking for a good stock to by. He said, " I believe the market is low… beaten down… but I can't seem to find anything that is going UP!"
Well, that's the nature of a super-bear market. Fighting the trend is risky. Check out my final results for the March condor legs… five winners and two losers. The five winners were bearish trades and the only two losers were bullish trades. If there's one lesson that teaches it's, "Go with the flow, baby"… "The trend is your friend". I guess that's two lessons, but you get the idea. There's a reason that I put on five bearish trades and only two bullish ones.
Good Trading…
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