Risk Management
Fujisan here. In my last week’s posting, I discussed hedging technique to protect the open positions, but I quickly learned that not many of you used this technique when the market edged up to retest the recent high. I saw some comments on Wednesday asking what they should be doing with their underwater Qs option spreads. Well, unfortunately, there is no magic adjustment to turn losses into gains, and that’s why it’s very important to exit the position at the right time. Without a proper risk management, you could quickly lose your capital, and options could be a highway to hell instead of heaven. Risk management is always a very important concept when it comes to trading, but it is even more important to option strategies, and that’s what I am going to discuss today. Loss on Investment Please take a look at this schedule. This is a summary of potential losses in Qs June bear put spreads with different strike prices if Qs makes adverse price movements. As you can see, the further Qs moves away from the entry point, the more the losses expand. This is the reason why you cannot “buy and hold” directional option spreads (there is a ”buy and hold” option strategy with delta neutral position, but that’s not what we are talking about). You have to have a very tight stop (both price and time stop) and active position management in order to avoid the “exponential” loss situation as illustrated above. But here is a question. How often would my stops possibly be hit if I have a very right stop? Very often. That’s why I’d rather have “hedging” strategy than a regular “stock loss”. I will discuss this further. Risk/Reward Calculation OK, we now know the importance of a tight stop. Now, here is another piece of the puzzle. If you expect to be taken out of the position, as often as 60%, then you’d better have a better risk/reward ratio, right? You bet you do! Here is what I do. I have a very specific entry/exit point, and I calculate the risk/reward (RR) ratio based on that. If RR ratio is below 300%, I won’t take the trade. I only take the trade if RR ratio is more than 300%. This is Qs 34/32 bear put spread P&L graph and these are my trading plans for this time around: Entry: 34.90 Immediate Target: 32.66~32.24 Stop Loss: 34.18 Time Stop: May 29 (if the position is not in the money, close it by this date). Risk Reward: $379 (reward)/$72 (risk) = 526% I normally trade in a much longer term (meaning a few weeks to a month), not in days, but these days, I am trading in a much shorter time span, and this is not what I’m looking for - but what can we do? The market doesn’t care how I trade. If I like to trade the way I do, I should probably stay out of this whipsaw market and wait for a major move — there are so much works to be involved and so little money to be made. I’m sure that many of you share my sentiment. In the mean time, I should trade small
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Risk Management