The OptionsANIMAL method and risk management.

Risk management is a critical component of successful investing. Without proper risk management, investing becomes little more than a haphazard activity which is unlikely to produce consistently positive results. Proper risk management involves a commitment to disciplined trading. In this article I’m going to discuss two broad areas of risk management. The first area of discussion is position sizing, and the second, following through on your “Secondary exits” (a bit of explanation “Primary exit” means that the trade is going to its expected outcome. “Secondary exit” means that the trade is going in some other direction than the Primary exit).

Before an investor places a trade he or she should have proceeded through several preliminary steps. These steps, referred to as the OptionsANIMAL method, include determining direction, generating trade ideas, selecting a specific strategy, and defining your exit points-both primary and secondary. Once those steps have been taken, and before the actual trade is placed, an investor needs to determine the final position size for this trade. Most professional investors will permit only a certain percentage of a portfolio to be at risk in any given trade. In so doing, the risk to an entire portfolio due to a single equity’s “misbehavior” is minimized. For me, the amount of risk that I am willing to take in any single trade is no more than 3% of the total portfolio value. By way of example, if I have a $100,000 portfolio that I’m working with, and I apply a 3% risk maximum to any one trade, then I am limiting the total risk of that trade to $3000. So, let’s say I want to place a bull put on XYZ with a five dollar difference in strike prices between my short put and my long put. In this example let’s assume a net credit of one dollar. My risk in this trade, by definition, is the difference in strikes minus the credit or, $5 -$1 = $4 per share. Since each options contract represents 100 shares, then my risk per contract is $4 x 100 = $400. Given that I am going to limit my risk to $3000, then the appropriate position size is 3000 / 400 = 7.5. In this example I would round down to seven contracts.

Different styles of trading have different risk considerations. For instance, the collar trade (long stock, long put, short call) may involve a significantly larger amount of the portfolio’s value since it requires the ownership of an equity. If I were to limit my risk in that type of trade to 3% of the portfolio, the trade might not make any sense at all. Furthermore, equities do not suffer from time decay (Greek: Theta), nor changes in implied volatility (Greek: Vega). In many cases the equity will also produce a dividend. So, what is the appropriate amount of risk that an investor should be willing to take when ownership of the equity itself is involved? That is a decision that each investor will have to make for themselves. For me, no more than 20% of the portfolio should be invested in any single equity.

The other broad area of risk management involves the managing of the trade when the secondary exit becomes more likely than the primary. This necessary component of risk management requires the investor to follow through on the pre-determined secondary exit actions. In some cases, it is appropriate to simply close the trade. However, if the investor spent an appropriate amount of time considering the secondary exits prior to placing the trade, then more than likely the trade can be adjusted and brought to a profitable close. There are two major styles of managing a secondary exit. The first being that the investor simply adjust the original trade into the predetermined secondary exit trade. For example, in the bull put stated above, the primary exit would have been for the stock to have stayed above the strike prices of both of the put options. A secondary exit would involve the stock declining in value such that the short put becomes an in the money option. A predetermined secondary exit for this trade would be simply to allow the short put to be assigned and then to collar the stock. The more advanced and sophisticated approach to managing a trade would involve the use of the Greeks. Using this approach the investor would manage the trade by making slight adjustments, adding or removing instruments, as the situation and your expectations changed. For example, using the same bull put as before, if the equity were to become bearish than an appropriate adjustment would be to change the net position Delta from a positive value to a negative value. This could be accomplished in several ways: one could simply by long puts, or sell bear calls or even short the stock.

Different types of trades will have different responses to the action of the underlying equity. Adjusting the trade using the Greeks is part art and part science. The science component can easily be mastered. The art component however, takes time and comes only after one has mastered the fundamentals of the options instruments and the adjusting process. Time and practice are required to master the art of adjusting.

Risk management is really a two-part process and a very necessary component of a successful investing method. It requires appropriate position sizing based on acceptable levels of risk and once in the trade requires the investor or to diligently manage the trade. In this way, risk can be appropriately controlled and the trade brought to a profitable conclusion.

Jeff McAllister
OptionsANIMAL Instructor

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