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Strategy Selection vs. Risk Management


"A billion here, a billion there, and pretty soon you're talking about real money." Everett McKinley Dirksen. Let’s begin with the bottom line: When I talk to anyone about the concept of choosing an option strategy (or two) to adopt for trading, I stress that the strategy should have certain characteristics.

First, it must be understood completely. It may sound trivial, but the trader must know how the strategy works and what must happen to the underlying stock for the trade to make or lose money.

Second, the trader must have confidence that this strategy is appropriate for his/her personality and comfort zone. For example, selling naked straddles (one call and one put, same stock, strike, and expiration) is a higher risk strategy that will appeal only to the most aggressive investor (and it’s likely your broker will not allow you to adopt that strategy). Even iron condor traders cannot just adopt that method in the dark. Strikes chosen and expiration dates play a big part in determining whether the specific trade is acceptable to the individual.

To trade options, it’s obvious that you must begin by buying and/or selling options. The combination of options – whether it’s a single option or a combination of several different series- defines the strategy. Thus, to play the game, you must adopt a position. Thus the strategy is your ticket. It’s your entry onto the playing field. It’s important to be comfortable with the choice, but it is not the only significant factor in your success (or failure). Risk management is more important (in my opinion). If you lose too much at one time, it's going to hurt your long-term results. Be careful and don't allow losses to overwhelm profits.

Selecting one or two preferred option strategies for trading is important because it gives you confidence that your methods can produce profits. There is no point in trading strategies that are recommended to you when you are uncomfortable with any aspect of that strategy. One simple example is the sale of cash-secured naked puts vs. selling put spreads. The former allows for larger profits but involves much more risk. The former is a reasonable play for investors who want to accumulate shares of stock on market declines.

If you don’t care to buy stock and especially if you prefer limited risk strategies, you are not going to be comfortable selling naked puts. If you adopt one of these methods for trading, it’s not that one method is vastly better than the other that should affect which you choose. Instead, it’s which is more compatible with your comfort zone and tolerance for risk. If someone makes good money with a specific strategy, please don’t believe that that strategy makes a good choice for you. Sure, consider that idea, but don’t adopt it just because it works for someone else.

Whichever strategies you decide to trade, your long-term results are going to rely more upon your ability to manage risk than upon which strategy you use. Many traders don’t recognize the importance of risk management until it's too late. By the time they understand that preventing losses is the name of the game, their trading account has been wiped out.

Options were designed to reduce risk. It's unfortunate that far too many rookies begin using options as tools for speculating in the stock market. And it's not only beginners. There's something appealing about using options as a mini-lottery ticket that attracts the attention of all traders. Some can resist, some cannot. As with real lotteries, the odds of success are against the investor who buys a handful of inexpensive, out of the money options, with the expectation that a miracle is at hand. An occasional win keeps them playing. That’s the way a slot machine takes your money. You lose money, make a partial recovery, and continue to play until the money is gone. To repeat: options were invented as risk-reducing tools. They are designed to shift the risk to someone who is paid a premium to accept that risk. There’s no need to minimize risk to the point that profits become unlikely, but there’s also no reason to make long shot plays with little chance of success.

Options are unique in the investment world

Options have specific risks that can be measured. Think about that. When you buy stock, your risk is simply that the stock can move lower, resulting in a monetary loss. But when you own a position that consists of options instead of shares, risk can be identified, quantified, and hedged. That's the subtle beauty of trading with options. When you adopt a specific strategy and make trades to implement that strategy, what you have really done is make an investment whose risk can be managed. When you own stocks the only way to manage risk is to sell some shares.

By understanding the risks, you have the ability to keep them under control. It may feel ‘more risky’ to have a position with specified risk factors – but the truth is that those factors can be reduced by taking appropriate actions - and that makes option trading different and far more effective than buying and selling stock.
What do those Greeks measure? Time decay (theta), exposure to a change in the market volatility (vega), being too long or too short (delta, or share equivalence). If you are familiar with ‘the Greeks’ then these risk factors are already known to you. The Greeks go further. They not only measure the rate at which certain risk factors affect the value of your position, but they also measures the rate at which those factors change (gamma, for example, measures the rate at which delta changes).

Taking the time to understand the Greeks is important, but I consider Greeks to have only one task. They allow you to quantify risk. How much can you expect to earn or lose if the underlying asset moves to this price or if the implied volatility changes by a 10%? Once you quantify risk, the decision becomes: Is that risk acceptable or do you want to hedge (reduce it)? That’s what makes options special.

If you don’t pay attention to managing risk, then you sacrifice the key factor that separates options from all other investments.

Most traders consider choosing a specific option strategy as the key to profitability. They speak of iron condors or selling naked puts as if those words can manufacture profits out of thin air. Only the more experienced trader understands that preventing losses and managing risk is more important.

Most reasonable strategies can produce good results - but market conditions must be appropriate. No one is going to suggest that selling naked puts works in a strong bear market, but if managed well, it can be a winning strategy for investors who like the idea of accumulating stocks whenever the market declines. I no longer sell naked puts, but at one time it represented a good portion of my trading.

Traders argue the merits of their favorite strategy. Which is most efficient for you to trade depends on many factors, including your personality and the effect of psychological factors. For example, see the discussion in Chapter 3 on covered calls vs. an equivalent method, put selling.

Your job, as risk manager for your portfolio, is to prevent those large losses from occurring. Your partner, the trader portion of your persona will try to convince you to relax your restrictions on how much risk should be allowed. Don’t give in. It’s okay to be a bit flexible on occasion, but you must make the final decision regarding risk. Too many traders lose sight of their long term goals when caught up in the excitement of the moment. Maintain your composure and your partnership will be everlasting and fruitful.

Bottom line: Choose a trading strategy that makes you comfortable, but manage risk carefully.
Choosing the ‘best’ strategy is not your objective.

  • The strategy does not make money
  • The strategy is merely your method of playing the game
  • The strategy tells you which options to buy and sell

Risk Management tells you

  • How many options to buy and sell (position size)
  • When to buy and sell them
  • When to take your profit
  • When to adjust or exit the trade

In other words, risk management tells you how and when to control risk to be certain you don’t incur large losses.
 

This post was presented by Mark Wolfinger and is an extract from his book Lessons of a Lifetime. You can buy the book at AmazonMark has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Mark has published seven books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.


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