Risky Business – Part Two

In my previous post I mentioned that I have several strategies for reducing my overall portfolio risk. This is an area I've spent a lot of time on, as I'm constantly concerned about any major hit my account might take. In case you haven't figured it out – I HATE losing… especially losing money. The first type of risk management I'll discuss is what I call Time Diversification.

When I evaluate a trade one of the things I consider is the possibility of spreading my capital across time. This works especially well for "campaign" style trading – those trades that I do every month on a consistent basis.

With condors, for example, I usually start about seven weeks out looking for my first entry point. I start watching the charts for a strong pullback opposite the trend for an entry point. If I can do it early in the week I will try to get the second side on before the week is over. My goal is to get the full position on that week because I'm going to want to get the rest of the capital on the following weeks.

The way I diversify over time is to allocate only 50% of my capital for this first week. The following week (about six weeks out) I will try to enter another condor with 25% of my capital, and then the final 25% during the following week or so. I don't have exact time frames for this. As I've explained many times, it depends on how the chart looks. Now why do I put 50% of my capital on the first week? Why not 1/3? There are a couple of reasons:

• By putting 50% of my capital to work up front I have more time to collect a larger premium. There is more time for decay, and therefore more time to collect.
  
• Sometimes it's hard to get all of the capital on… the charts just don't cooperate with my after-hours trading schedule. By starting out with 50% on I can at least get the lion's share in play, while still providing some diversification.
  

Spreading the capital across time accomplishes one of two things. On the one hand, it might allow me to spread my trades across a wider range of strike prices. If that doesn't occur because price stays flat, I can still add to my position with some confirmation of a fairly steady market.

So, what does this do for my overall risk tolerance? As I mentioned in the previous article, my overall tolerance for risk is 2% of my total capital per trade. In other words, in a worst case scenario I don't want my account going down more than 2% because of this trade. That part of my plan never changes, but this does change my capital allocation for this trade. Let me work through an example to explain:

• Let's say I have an account of $10,000. I don't want to lose more than 2%, or $200 in a trade. My maximum loss for a condor trade is a loss of about 10% for that trade. Therefore, I can risk $2000 of capital out of my $10,000, because if my max loss happens I will lose 10% of the $2000, or $200 (2%). Hopefully that makes sense… in short, $2000 capital = $200 risk.
  
• Now, if I break the capital apart and spread it across time, I believe it reduces my risk. How much? Who knows. I'm not a good enough mathematician to figure it out, but my point is that More than $2000 capital = $200 risk. I wish I had a way of pinning down exactly how much more, but I'm not sure how to measure it. In any case, I should be able to employ more than $2000 capital using this approach without increasing my 2% risk.
  
• So what have I done? Absoutely nothing. As far as Time diversification goes, I believe it reduces risk, but I don't put more capital at risk. In other words (for the example), $2000 capital = Less than $200 risk. I am doing well enough in deploying capital right now that I've chosen to simply reduce risk.
  

Good Trading…