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Be aware of the risks

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Today I want to talk about risk.

If you have looked into some other options services, you probably have seen it:

"Learn to Trade in Just 7 Minutes a Week"

"This strategy brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +"

"Selling credit spreads is a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account.”

"Trading with just $25,000, our members can earn between $2,500 to $3,000 in monthly income"

Those are real examples from real services. You won't hear such promises from me. Options trading is not easy and involves a lot of risk.


Let's see some examples of the risks.

  1. You buy a call. Then you set a stop loss of 25% and think you are safe. The next day, the stock gaps down 10%, your option gaps down 60% right through your stop loss.
  2. You sell a credit spread. You think you are safe because you hedged yourself with another option. But if the stock goes beyond your purchased option strike, you still lose 100% of the margin.
  3. You buy a covered call. You think you are safe because you protected your stock. Then 2008 crisis comes. Your stock is down 60%. Your covered call reduced the loss by 5%, but you are still down 55%.

I can go on and on, you got the idea.

Now let's talk about our earnings plays.

The idea is to buy a straddle (or a strangle) and let the increasing IV to offset the negative theta. As you could see from our results, even if it doesn't happen, the loss is usually fairly small, most of the time in the 7-12% range. Sometimes the loss can be 15-20%, and our biggest loss this year was 25% (two 25% losers out of over 100 trades).

However, it is possible to lose much more than 25% on those trades. When it can happen?

The biggest risk for those trades is earnings pre-announcement or early announcement. It happens when a company releases its earnings earlier than scheduled. It happened to us two times this year: with ORCL and COF. In both cases, we were lucky enough, the stock moved after the announcement and the trades have been closed around breakeven. In fact, some members waited and were able to close the COF trade for 30-50% gain (this was pure luck, and we don't want to rely on luck in our trading).

Now, imagine what would happen if the stock didn't move. We owned the COF 55 straddle, the stock was sitting right on the strike, and it was 1 day before expiration. With IV collapsing, and very little time value left in both calls and puts, the risk of 70-80% loss was real. The fact it didn't happen so far doesn't mean it will never happen.

Why I'm telling you this and how can you mitigate the risk?

My goal is not to scare you. I still think this is one of the safer options strategies. But "safer" is not equal to "no risk". Every strategy has its risks - if someone tells that he found a holy grail, please don't believe him. I want my members to be aware of the risks and to handle them.

The most obvious way to control risk is via position sizing. Never allocate more than 10-12% to a single position. One way to reduce the risk is to allocate less capital to weekly trades. By its nature, they are more risky since most of their value is in IV and there is very little time value. Be especially aware of companies that have a history of pre-announcements.

On a separate note, I would not trade very large amount of contracts for those trades (or any options strategies). I don't want you to put all (or most) of your trading capital into my service (or any other service). No strategy will work all the time or under all market conditions, so please diversify. Be always aware of liquidity. Always look at the OI (Open Interest) - as a rule of thumb, don't trade more than 10-15% of the OI.

Please let me know if you have any questions.

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Jesse, this is a very important question, and I have to comment.

While those strategies are scalable, they are scalable only to some degree. When you have a 100k account, there is no problem to place 10k to each position. With 1M account, I wouldn't do it, for several reasons. First, as I mentioned, while the chance to lose 80% of the trade is very small, but it does exist. How comfortable would you be to lose 80k in one day, even on 1M account? Second, I think the bigger your account, the more diversified you should be. Yes, it is all relative, but still - with 1M account, I probably would not place more than 5-6% per trade. Then there is a liquidity issue. With 100k trade, you need to trade 200-300 contracts. With stock like HAL, I don't know how realistic it is. So the solution might be to spread it over more positions. In my model portfolio, I have place only for 4-5 positions, but during busy earnings period like now, I post more discussion topics that have decent candidates, so members with larger accounts can trade more positions.

What I'm saying is that liquidity is a factor in any strategy. Big accounts can trade only bunch of vehicles, this is a well know fact. While it is more critical for stocks, it is important for options as well.

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Good post Kim. Thank you.

I think your point on using monthlies over weeklies is also a great one.

In the past one of the members mentioned using "GUTS" to reduce the risk, but in the limited backtesting I did, I did not see using GUTs returning a profit very often. Do you have any experience on this?

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Only one point I would argue, properly sized, trading options is not any riskier than going long or short a stock. Its like hunting with a high powered rifle rather than a bow and arrow. Both can shoot the game, one much more efficiently. Used carelessly, both can be very dangerous.

The key point is understanding the risks, and managing them. Most of the strategies pursued here are fairly low risk, but not immune. Especially if you accidentally hold through earnings, that will either make you really happy or really sad ;)

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You make a good point about diversification, including not relying too much on this service (or any other). It begs the question, what other services are available that have proven themselves to be high quality, profitable services in the long run? I'm sure there are SO members that have tried other services and some of them may have turned out well. (I'm sure horror stories are even more common, but I'd rather not open that can of worms here.) How about a discussion of other services which might complement SO and diversify our portfolios?

Based on some of Kim's and Chris's posts, I can see a day when SO expands to include strategies other than pre-earnings volatility plays (well, it already does with the calendars and ICs) as a more diversified service, perhaps using additional market trend indicators to overweight and underweight the various types of trades at different times. Until then, some of us might like know where we can diversify our trading strategies, without falling into one of the many traps out there.

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Jesse, a name would help us to evaluate on our own. I do not see why Kim would object, he himself mentioned the guys at NextOptions, a few times, whom I tried and like. As long as we open a separate topic for this, I see no harm. My opinion, of course.

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