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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 Amazon. Mark 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. Related articles Trader Mindsets How Much Can I Earn With Options? Trader’s Mindset: Oblivious To Risks Managing A Losing Trade Learn First. Trade Later Adaptability And Discipline Maybe The Market Will Turn Around Trader’s Mindset: Always Collect Cash The Art Of Trading Decisions Managing Risk For More Than One Position My Philosophy On Options Education Trade Decisions: Risk Or Profits?
This trader is short two put spreads. One in YHOO (Jul 23/24) and the other in RUT (Jul 920/925). These positions began as iron condors and the calls were covered at a cheap price. "I’m not sure of what I should do. When adding these two positions together, the ‘portfolio’ is too delta long for my comfort zone." === RUT === I could offset the positive delta of the put-spread by shorting another call-spread. But that is somewhat inconsistent with my belief that I should initiate positions with at least two-months expiry. What would be more consistent is if I closed the put-spread and opened another Iron-Condor with a later expiry. The only thing is that in order to exit at break-even… This is somewhat expected as the volatility conditions for this trade were less than favorable. Another option would be to roll-down the put-spread. This would reduce the amount of positive-delta, but still leave the portfolio with positive delta. I guess I will be looking to exit the RUT put-spread today. [Note: Position was closed @ 1.20] My response: Be careful about measuring portfolio delta. One RUT deltas is much more significant than one YHOO. a) Delta is the change in value for an option when the underlying moves ONE POINT. One point for YHOO is a big move. One point for RUT is insignificant. b) The YHOO spread is only one point wide and the max price for the spread is $100 c) The RUT spread is 5 points wide and the max loss is $500 (less credit collected) d) Delta is a good guide for for current (imminent risk), and the risk graph shows how bad things can get when such and such happens. But as to your comfort zone, the RUT position is far more ‘dangerous’ because more cash is at risk and RUT will move many more points than YHOO on almost every trading day. e) Also consider that RUT is 40 points OTM. I am not suggesting that this is ‘safe’ but the question is: how do you feel about it? If this makes you nervous, yes, do exit. Especially today with a small market bump and a small IV decrease (RVX is -.77 as I write this). Adjustments Yes, selling another call spread is a viable adjustment. It is one way to maintain delta neutrality. However, when a trader looks at the current market, it is very difficult to sell call spread now that the DJIA has declined by more than 500 points in the past two days. The ‘best’ time to sell that call spread is immediately after covering your previous short spread. But selling another call spread is not for everyone. This is a difficult decision and I cannot offer guidance. For my trading, I do occasionally sell another spread after covering, but most of the time I do as you did: nothing. There is a world of difference between initiating positions and adjusting positions. When initiating a new trade, you have the ability to wait until conditions suit your needs. There is no urgency. You can easily satisfy that need for a minimum of two months. Adjusting requires a very different mindset. Your objective when adjusting is to reduce risk. NOW. It is not to make more money from the trade. It has nothing to do with future profits. It is only about one thing: recognizing that this trade has gone awry and you want to give yourself the best opportunity to stop the bleeding. Primary goal: make the position less risky, reducing the immediate cash at risk. Secondary goal: Create a position that you want to own (do not blindly adjust and hope for the best) and which gives you a good (this is where your judgement comes into play) chance to make money from THIS POINT. Do not worry about past losses. Do not trade to recover those losses. Trading to get back to even is a losing mindset. Traders make plenty of poor decisions trying to recover losses. Closing the put spread and opening another iron condor is a good idea. But ONLY when You do not allow the idea of ‘break even’ to be part of the decision. Please take my word for this. I know what it is like to roll the old position into a new one, choosing the new position based on its price (in other words, paying zero debit or collecting a cash credit for the roll), giving myself the chance to earn my original profit target – if only the new spread would expire worthless. When the market is trending this style of trading is financial suicide. Be willing to take the loss and independently find a suitable new position. You want to exit the current position because it is not one you want to own. The new iron condor is one that fits your trading criteria. Far too often traders make this ‘roll’ just to do something. Do not fall into that trap. You understand that doing this is two separate decisions. Close when you believe that is best. Open a new trade when you find a good one. Do not feel you must open that new trade at the same time the old one is closed. Yes – I know the need to get a new position so you can recover losses. Nothing wrong with wanting that new trade. Just make it a good one and do not allow the thought of getting back your money be part of the decision process. Yes, rolling down the put spread is viable, when two conditions are met. The cash debit required is not more than you are willing to pay The new position is one that you want to own. The important point of this post is that one YHOO delta is not the same as one RUT delta.
This is sad, because without a suitable size for the positions any method of negotiation will be incomplete. Many people avoid monetary and risk management issues because they realize that controlling risk will not get rich. But the fact is that you will not get rich at all if you do not learn how to manage money. One of the pillars of the industry is the search for the holy grail and in fact the industry is in love with the trading systems. Many traders, especially those who go through that initial phase of frustrating losses, are looking for mechanized trading methods that simply generate input and output signals to follow without asking questions. However, they rarely seek a "monetary management system" capable of generating clear "signals" about how to adjust and manage the size of positions. But the reality is that these techniques exist and, despite being mechanical, are much more effective than the signal generators of buying and selling. Have you ever considered the following: If money is earned through trading systems, why do the vast majority of traders end up without profits or losing money? This is not due to the lack of consistency of forecast resources or services that are available for every trader. This is due to monetary management, which is practically a last minute idea for many traders. Just Bad Luck or an Immutable Mathematical Law? Let us now turn to the playing field of the negotiation: here, the percentage of Winning Operations and Profitability can vary with the change of market conditions. The only parameter that the trader can effectively change is the risk. We will use the example of the launching of a coin to present some fundamental concepts of risk management. When we flip a coin, our luck is equal to a 50% winning transaction percentage. The risk is the amount of money that we play, and therefore put at risk, on the next release based on the payment ratio. In our example, our "luck" and our payment remain constant. Following the example of coin tossing, it does not matter in what order the faces and crosses appear. If we first take 50 crosses and then 50 faces, the result would be the same as if we took 50 faces and then 50 crosses. In options trading, the order of the operations that are performed, as well as the result of any operation are almost always random. Therefore, from a risk control perspective, it is not advisable to stick to or emotionally the result of an operation or a series of operations, nor financially risking too much. To understand that what appears to be an unlikely outcome is, in fact, possible we need the help of the Law of The Large Numbers. The Large Numbers Law tells us that a random event is not influenced by previous events. This explains why the percentage of Winning Operations in a system does not increase even if the system has recorded 20 consecutive losses. While it is true that recent operations affect the overall percentage of Winning Operations, many operators enter the market thinking that a corrective move should occur, simply because they have had several consecutive winning or losing trades. In doing so, they are expressing the belief in the so-called "gambler’s fallacy". This brings us to the next point: imagine that you think you are unlucky after a really bad loss streak when it seemed like you had found a winning system. If there was a way to know how long a streak will last … Well, if you know the probability of an event (percentage of Winning Operations) and how many times the event will take place, there is a mathematical formula that will indicate the maximum number of winning and losing streaks. But in trading the number of times the event occurs is not known, since it can cover your entire life as a trader. If we knew the number of operations that you will perform during your life, you could calculate the maximum number of consecutive losses, provided that the percentage of Winning Operations remains exactly the same. By varying the percentage of Winning Operations, the number of consecutive losses will improve or worsen. But it is impossible to know both numbers in advance. The Ralph Vince Experiment Ralph Vince conducted an experiment with 40 doctorates without previous training in statistics or trading, which were given a simulated computer trading environment. Each of them started with $ 1,000, a percentage of Winning Operations of 60% and they were given 100 transactions with an Expected Payment of 1:1. At the end of 100 tests, the results were tabulated and only two of them earned money. 95% of them lost money in a game in which the odds were in their favor. Why? The reason they lost was the belief in the gambler's fallacy and the resulting poor monetary management. Greed and fear were used to calibrate operations. The aim of the study was to demonstrate how our psychological skills and our beliefs about random phenomena are the reason why at least 90% of people who have just reached the market lose their accounts. After a series of losses, you tend to increase the size of the bet by believing that a winning operation is now more likely - that is the gambler's fallacy, since the odds of winning are still 60%. If you want to learn how to treat options trading as a business and put probabilities in your favor, I invite you to join us. Start Your Free Trial Related Articles: Why Retail Investors Lose Money In The Stock Market Are You Ready For The Learning Curve? Can you double your account every six months? How to Calculate ROI in Options Trading Performance Reporting: The Myths and The Reality
simpleThought posted a topic in General BoardLong post. Bear with me as I try to accurately capture my situation. I have netflix employee stock options that I want to sell over the next 5 years. Not at the same time to avoid too much of short term tax (they are considered regular income as I generally exercise and sell on the same day). Now, there are several ways of doing this from my knowledge on options which I am gathering last year or two, though with minimal actual option-trading experience. But, still not sure what is the best course of action and hence I am posting this here. I don't own the stocks and hence covered calls are out of question if someone is thinking that. This is purely a optimal protection strategy. The possibilities are (assume 100,000 in the current market value minus cost for ease of calculations): 1. I buy put options covering 20% of the options till Jan 18 as insurance and exercise the call options (ESOP) and the put options if they are in the money. Now, these put options can also be of different kind. 1a. Pay 18 USD (as of 04/24/17) for 150 usd strike price (let us assume that 2 contracts will protect 20 % of the stock options) 2a. Pay 10 USD for 135 usd strike price. This is one thing I came up with in terms of insurance as an example. What are the other methods through which I can protect my ESOP (employee call options that have a longer time horizon), if I don't want to sell them all at once? Sorry about the long question, but hopefully I made it clear. If you are clear about his question and have a great knowledge and want to help, I appreciate a direct message as well. Thanks a bunch in advance. One thing I realized is that even if this protects the 20%, there is no quarantee that stock price will stay the same and hence I am exposing the remaining 80% for the next 4 years. May be I am overthinking this...I am sure you guys will set my brain straight.