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These conclusions reveal how maximum profit and loss are calculated and aid in deciding which strategies are good fits for your risk tolerance. Does risk level justify the trade? That is where most options traders begin to address probability. But most often overlooked in selection of an underlying for options trading or for a strategy to be used, is the comparison between probability and risk. Too many traders consider these as the same thing. If probability of profitable outcome is high, it must mean risk is low, and vice versa. Most options traders make this assumption intuitively. Based on proximity of price to the money, time to expiration, and relative status of long or short positions, probability and risk are well known. But what about the correlation between the two, probability and risk? Probability often is the result of a calculation and may be viewed in isolation; the true risk level might not be considered at all, or simply assumed to be conclusive based on what probability reveals. This is a mistake. The correlation of probability and risk Once you decide a strategy is “low risk” what comes next? You might overlook a related next step, the possibility that risk changes once probability increases or decreases. A simplified example is how the probability of a profitable outcome changes when the underline moves unexpectedly close to the money. Does this mean risk is higher or lower? It might. But the point – comparing evolving probability and risk – could also be more subtle. Here is an example: A trader likes short puts because the market risk is identical to that of a covered call. Opening a series of short-term, slightly OTM short puts produces profits consistently and exercise is avoided by early close or rolling forward. But what if the company will be announcing earnings the day before last trading day? What if the company has a history of double-digit earnings surprises? Does this change the probability of profitable outcome? And does that make the risk picture entirely different as well? Yes. Of course, but the degree of risk in holding onto the open position with little or no “?buffer zone” point spread, also defines degrees of risk. The point is that neither probability or risk are absolute factors in judging options and their likely outcomes. There is a tendency among traders to want a binary answer. Is probability high or low? Is profitable income likely or unlikely? The answer depends on other factors like moneyness, time to expiration, historical volatility, earnings reports and likelihood of earnings surprises, and the unexpected announcement that often shows up at the worst possible time. These announcements include merger rumors, SEC investigations, accusations of financial wrongdoing by the top executive, product recalls, class action suits, strikes, natural disasters, and more – the list goes on and could be endless. Another way the correlation works addresses the problem of tied up capital and margin. If you are holding stock especially for use with covered calls, is your probability of loss low? Probably. But is the risk high? In some respects, it might be. For example, the lost opportunity risk of tying up capital for covered calls is rarely discussed by anyone. But it exists. Your capital is tied up in holding shares while you write covered calls. Probability of loss is low, but lost opportunity risk can be very high. Covered calls offer limited maximum profit equal to the premium of the covered call. Could that same amount of tied-up capital be used elsewhere to generate more attractive profits? That is a question with any number of answers, but the point is that in this situation, risk and probability coexist but may be influenced by different things. Anyone who tries to lower risk by keeping their money in low-yielding money market products has accomplished a low probability of loss, at or close to zero. At the same time, they accept a high risk of true net loss, at or close to 100%. This is so because the combination of inflation and taxes virtually guarantees that the low yield on savings cannot produce an after-inflation, after-tax profit. This paradox is real-world stuff, not just theory. It is possible to combine low probability of loss with high risk of loss, in the same product. The example of money placed in a guaranteed, low-yielding account demonstrates how this works. In the world of options, the variables are more complex, but the same point must be made. In options trades, you can lower the risk of loss while improving the probability of profits. For example, if you time trades for those rare moments when the Bollinger Bands exceeds upper or lower band by three standard deviations, the probability of an immediate reversal is close to 100% because the range never remains that far from the center line for long. If you time covered calls for the Friday one week before expiration, you drastically reduce risk because options lose one-third of remaining time value in the one trading day (but three calendar days) between Friday and Monday or expiration week. Does this mean it is possible to set up a foolproof system to make a profit consistently? No, that is never possible. But it does mean something almost as promising: By understanding the events and timing that affect probability, the risk of loss is drastically reduced. Most options traders will agree that this is good enough, given all those variables that tend to get in the way of every “perfect” system ever devised. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook. Related articles Is Your Risk Worth The Reward? Risk Reward Or Probability Of Success? Calculating The Probability Of Option Payoff Option Payoff Probability Probability And Option Risk
The "greed and panic" factor is not unique to options trading. Everyone who has bought stock and lost a big segment of capital knows all about it. The price moves rapidly up so you buy more, and then it all evaporates when the price reverses. Or the price moves down and you panic and get out just before prices rebound. It's the old "buy high and sell low" strategy, when we all should be buying low and selling high. With options, the tendency is the same even while the product is different. Some traders forget that today's price of anything is just the latest in an unending series of price swings. It is not a starting point or the ending point of value, and despite the best intentions, price does not move in the direction we want only because a trade has been opened. Options traders, like everyone else in the market, is vulnerable to wishful thinking. The first step in overcoming this all too human tendency is awareness. Deciding when to enter should rely on several attributes. These include volatility as well as skillful chart reading and recognition of emerging patterns, notably reversal patterns. It also relies on a study of fundamentals and knowing how those affect the technical side. Once in a position, decide when to exit. Set goals for yourself so you know when the timing is right to take profits and move to the next trade. Your goal should set a profit target based either on dollar amount or percentage of return; also set a loss bail-out point, where you will get out of a losing trade to minimize net losses. You're better off booking a small loss than a total loss a few weeks later. This is not as easy to follow through, but it's important to increase overall profits. Succeeding with setting goals and following them is tough, but worth the effort. The key to effective use of options is to use them to manage and hedge risk, not to replace one risk with another one - especially when the new risk is based on greed and panic rather than on trend watching and logical analysis. As the old adage reminds us, bulls and bears can both succeed in the markets, but pigs and chickens get slaughtered. So if you are most interested in low-risk trading, a quick and easy solution is to know your markets. This ultimately may be the secret to success in options trading. Knowing when to act, either on entry or exit, and also being able to follow through on profit and bail-out points, overcomes the tendency to demand either triple-digit profits or complete losses, and settle for nothing else. The true contrarian succeeds in trading options. This often misunderstood method is not merely doing the opposite of the market crowd; it is an observation of motive. Most traders act and react emotionally. The contrarian uses cold calculation and analysis, resisting the emotional urges of greed and panic. The contrarian must apply strong discipline to go against the majority, remembering one crucial point: The majority is wrong more often than not. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
Here are just a few of the shattered risk-related records, a sample of 3 each for the Dow and S&P: Dow: Dow Industrials intraday volatility, lowest on record (95% of days in 2017 had less than a 1% Dow intraday move) Dow Industrials greatest number of days in history without a 1% move (72) Dow Industrials closed at new all-time highs a record 71 times in 2017 S&P 500: S&P 500 annualized volatility of 3.9%, lowest on record S&P 500 Total Return Index gained in every month of 2017, and ended the year at a record 14 consecutive up months S&P 500 ended the year with a record 289 consecutive days without a 3% pullback VIX: Lowest intraday level in history (8.84 on 7/26/17), Lowest daily close (9.19 on 10/5/17), Lowest weekly close (9.36 on 7/17/17), and Lowest monthly close (9.51 on 9/29/17). 2017 also serves as a reminder that future is unknown. Nobody was predicting this to be the least volatile year in modern history. They were predicting just the opposite, in fact, even after the year had already begun… Additionally, US equities have now posted positive returns for nine straight years, tying the record from 1991-1999. I could go on and on, but you get the idea. Some years from now, we'll look back and agree that 2017 was the "exception that proves the rule," and that risk indeed still exists, and must be dynamically managed for long-term success. In my firm, all of our strategies include dynamic risk management, either in the form of option hedging with our Anchor strategy or with trend following rules that react to weakness in equity prices by partially or entirely exiting positions to protect capital. After all, do we demand that the fire department be disbanded as a waste of time and money when a neighborhood experiences a year with no fires? Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.
If the options were out of the money, and remained OTM, then the options would expire worthless and the seller would have a tidy profit. I can’t argue with the 2nd sentence. Options that are OTM once expiration day has come and gone are worthless. However, that mind-boggling first sentence is believed by more people than common senses would suggest. Once of the basic truths about investing (even when it would be more truthful to refer to it as gambling) is that some people with little experience believe that it’s easy to make lots of money in a hurry. I don’t know why that’s true, but the fact that skills must be developed over time is a foreign concept to such believers. Confidence that a current investment will eventually work out is common. Stocks decline and many investors like to add to their positions, increasing their risk in a losing trade. The mindset is that the stock only has to rally so far to reach the break-even point. For example, buy 1,000 shares at $50, then buy 1,000 shares at $40 and the beak-even is ‘only’ 45. Add another 1,000 shares at $30 and the trader’s mindset is that this stock will easily get back to $40, the new break-even price. There is no consideration for the possibility that this company will soon be out of business. This investing newcomer just knows that his original analysis must be correct. This is the mindset of overconfidence. In a situation such as this, it’s also being oblivious to the real world. The naked put seller The put seller described above believes that being short an out of the money option is of no concern, as long as it remains OTM. He just doesn’t get it. The possibility of losing a significant sum is staring him in the face and he truly doesn’t recognize the danger. I’m not suggesting that this oblivious mindset is common. However, as option traders we must be careful to avoid that mindset. I’m sure that every reader here understands the risk of being short naked options. However, being oblivious to other risks can result in a disaster. How large of a disaster? That depends on just how blind the trader is to the true risk of a position. If you are not a member yet, you can join our forum discussions for answers to all your options questions. The spread seller As an example, let’s look at a trader’s whose preferred strategy is to sell OTM put spreads, rather than selling naked puts. This is a common strategy for bullish investors. Let’s assume that one trader correctly decides that selling 10 puts with a strike price of $50 is the proper size for his/her account. Even oblivious traders understand that the maximum loss is $50,000. They also recognize that the chance of losing that amount is almost zero, and that it is difficult to know just how large the maximum loss is. Sure, a stop loss order can establish that limit, but stocks have been known to gap through a stop loss, leaving the trader with a much larger loss than anticipated. The ‘flash crash’ was an extreme example of how bad things can get. What happens when this trader decides that selling naked puts is no longer the best idea and opts to sell 5-point put spreads. Each spread can lose no more than $500 (less the premium collected). The problem arises if the trader, not understanding risk, decides that selling 100 of these spreads – with a maximum loss of (less than) the same $50,000 – is a trade with essentially the same risk. When a trader is not paying attention, he/she can become blind when the total money at risk is similar for two different trades. It’s easy to incorrectly believe that risk must be similar. In this example, two positions have vastly different risk. Position size and probability The trader whose mindset includes being oblivious to reality, is either unaware of statistics or ignores them. The big factor here is probability. There is a reasonable probability of incurring the maximum possible loss when selling 100 (or any other number) of 5-point credit spreads. Depending on the strike prices and the volatility of the underlying, the chances of losing it all can be near near zero to almost 50%, depending on the strikes chosen. Let’s ignore the ‘near zero’ examples because the premium available when selling such spreads is tiny and no one should be trading those on a regular basis. However, when the chances are one in five, or even one in 10, you know that such results are going to occur (on average) every five or ten months. It takes some good sized wins to be able to withstand those losses. But the truth is that the trader who is not aware of the difference between the chance of losing $50,000 no more than once in a lifetime vs. losing that amount at least once every year has no chance to find success. One important aspect of risk management is understanding how likely it is to collect he profit or incur the loss. The size of that profit or loss is not enough to tell the whole story. Please do not be an oblivious investor. Please understand risk and reward for every trade, as well as for your entire portfolio. Related Articles Probability Vs. Certainty Trap Adaptability And Discipline Selling Naked Put Options Should You Add to A Losing Trade? Want to follow us and see how we trade options while reducing the risk? Start Your Free Trial