What’s in your portfolio?

April 14, 2013 / Jeff McAllister

One of the benefits of being a coach for OptionsANIMAL is that I get to see the paper trading portfolios of our students. To say that I have seen some
interesting trades and some interesting portfolios would be an understatement. Most of the time the portfolios and the trades are good. However, one area
that seems to need constant reinforcement and correction, occurs more often than I would like. That area is the lack of determining the cumulative effects
of secondary exits.

At OptionsANIMAL we teach our students to determine both their primary exit (when to close a profitable trade), and their secondary exits (what to do if
you’re trade does not conform to your initial expectations). Many times the secondary exits require additional capital. Take for example one of the most
common trades placed by options traders; the bull put (a spread trade where a put is sold and another put is bought at a lower strike price than the sold
put, with both options in the same expiration series). Because the sold put creates the obligation to buy the underlying equity at the strike price of the
sold put, a typical secondary exit would be to take ownership of the stock if the sold put were to be assigned. From there, typically we would adjust the
stock ownership position into a very common equity based trade called the collar trade.

A very straightforward adjustment to be sure. Typically, the initial trade (which could be considered a complete loss), is not only made up for, but a
profit may be generated within 2 to 3 months. Because of this characteristic of selling a put vertical, the fear of the trade going against the trader is
minimal. So, typically what I see happen is that a student will place numerous bull put verticals into a portfolio. The tendency is to have too many put
verticals. The danger with this approach is that there may not be enough capital available to follow through on the secondary exits of all (or at least
many) of these open trades. It is not question of if the market will correct, but rather a question of when. Since the when is unknown we must always be
prepared for that eventuality.

If your secondary exit is planned to be ownership of the underlying equity, then you need to ensure that you have enough capital available to actually do
so. Furthermore, if you have more than one put vertical in your portfolio you need to make sure that you have enough capital available to follow through
ultimately on all of them. Without doing so exposes the trader to the potential for significant loss. Since the trader will not be able to follow through
on their secondary exits, they will have no choice but to close trades at a loss! If you are closing trades at a loss it implies that you either have not
considered your secondary exits or you have failed to ensure that you have the capital available to do so. Having a plan without the ability to follow
through on your plan is no plan at all. You must have the financial capability to follow through.

So how much capital do you really need? Well that’s going to depend on the types of trades that you are initiating and your planned secondary exits. If the
secondary exit involves buying the equity you have to have enough capital to buy the equity. If the secondary exit is to turn it into a diagonal or
calendar then you need enough money to buy the longer-term option.

The critical step that many seem to miss is that it is not enough to simply know what the capital requirements are for your individual trade, but you also
must add up the capital requirements for all of the trades in the entire portfolio. Failure to do so can lead to disaster. It really isn’t a question of if
the entire market will move against your portfolio at some point in the future. It is simply a question of when. Ensuring that you have the capital
available to follow through on your secondary exits eliminates the possibility of having to close trades at a loss. So, the professional investor/trader
knows that proper portfolio management means that you have to take the time to look at the worst-case scenario for each of your trades and then summarize
the entire risk of the entire portfolio. In so doing, you might be surprised by just how much risk you are exposing your portfolio to. The end result might
mean that you need to scale back on the number or size of open positions in your portfolio. At the very least, by taking this extra step you will know that
you can in fact follow through on your secondary exits. Without this knowledge, without this vital information, you are not ready to trade.

Jeff McAllister