Option Investor
Educational Article

Managing Risk

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Balancing risk and reward is at the core of what we do as traders. In the search for trades that provide a favorable potential return vs. the attendant risk, we employ a seemingly endless array of technical indicators, studies and empirical parameters. Each of us have a different approach to managing risk, so proposing a method of managing that risk that is applicable to all (or even most) traders is a practical impossibility. But there are some basic tools that all traders can use to better control their risk in these volatile markets.

The first and most important tool (in my opinion) is the disciplined use of stop losses. Frequently emotions can interfere with rational decision making once a trade is entered and having a stop loss in place helps to take the emotion out of the equation. Whenever I write about stop losses, I invariably get a series of questions on what type of stop loss order to use and what are the differences between them. I recently wrote an article on that topic, so if you have questions along those lines, I would encourage you to read that article at Managing Risk With Stop Orders. Another way to control the emotional aspect of a trade is to make sure that you aren't trading too large of a position size. If you find yourself controlled by emotions on a specific trade, then it is a safe bet your position size is too large. Experienced traders will recognize that feeling and immediately trim the size of the trade as a method of bringing their emotions back under control.

While stop orders are an essential tool for risk management after a trade is opened, what I want to talk about is controlling your risk before the trade is opened. In my experience, traders essentially fall into one of two categories. Momentum traders prefer to trade breakouts or breakdowns on the theory that once an important support or resistance level is penetrated, the move that created that penetration will likely continue. In the other camp, we have the dip buyers, who prefer to initiate new bullish positions on a rebound from support or new bearish positions on a failure to penetrate resistance. I'm not here to promote or denigrate either approach. Either one will likely work equally well, provided the trade has been well-considered in advance of entry.

Momentum traders will manage their risk with stop losses set just below resistance on a breakout or just above support on a breakdown. If the breakout falls back under the broken resistance level, it is usually a sign that there is insufficient buying pressure to keep the stock rising. Similarly, if a stock breaks down through strong support and then rallies back above that support level, the market is telling us that the stock is not as weak as the initial breakdown would have led us to believe.

I personally tend to favor buying dips and selling rallies because of the way I like to manage risk. There have been a lot of failed breakouts and breakdowns recently, as once the primary move through resistance or support has taken place, there is frequently insufficient buying or selling to keep the move going. Buying a rebound from support allows me to place a stop just below that support level, keeping risk manageable. Likewise, selling at resistance provides the ability to place a stop just above that resistance level, as a rally that takes the stock above that resistance level gives a clear indication that my rationale for the trade is in error.

To help clarify the differences in these two strategies, let's take a look at a daily chart of IBM, which has provided solid entries of both flavors in recent weeks.

IBM Daily Chart

After bouncing along the $65-66 support level for a solid month, those bounces from that level in late July and early August provided attractive entries to the long side for those (like myself) that tend to favor buying bounces from support. Risk could have been managed with a fairly tight stop at $64.50, which was just below the lowest intraday levels of the prior month. By mid-August, the momentum traders got their chance, as IBM blasted through the $74 resistance level. Traders that took that entry were able to manage their risk with a stop at $72, just below the level of resistance that had been holding Big Blue back.

That rally ran its course within a week, as IBM ran into a veritable brick wall at $83. That gave the bears their opportunity to pile back on as the rally failed. Risk was simple to manage here as well with a stop at $84, just above the highs posted on the preceding rally. And then last week, eager bulls were back in the driver's seat, nibbling on the stock near the $72 level. Note that the stock found support at prior resistance in the $71-72 area, as prior resistance became new-found support. Positions taken near the bottom of the most recent pullback would have been protected with a stop near $71.

Hopefully this discussion has given you a better picture of how both types of traders can manage their risk in an uncertain and volatile market environment.

There is another aspect of risk management that I think is frequently overlooked. As option traders, we frequently find ourselves buying at the Ask price and selling at the Bid. The difference between these prices is the spread that the Market Maker collects as his fee for making a market in a given security. The magnitude of that spread is directly related to the Open Interest and Daily Volume in the option in which we are considering a position. The term "Liquidity" is used to refer to the ease with which we can enter or exit a given position, and prudent option traders will take this factor into consideration in their trading plans.

We can use a couple of stocks currently on the OI Call list as an example of how to manage this risk. MSFT is currently trading just south of $49 and normally sees from 40-50 million shares traded on a daily basis. This heavy volume translates into the options market, with front-month ATM options trading between 1000 to 12,000 contracts on a daily basis. The open interest on the SEP $50 Calls is currently more than 42,000 contracts. This is a perfect example of a highly liquid option contract and a measure of this liquidity is seen in the narrow spread between the Bid ($0.80) and Ask ($0.90) prices.

In contrast, SPW (currently trading near $112) trades less than 1 million shares on a daily basis, and even the ATM (actually slightly OTM) SEP $115 Call only traded 50 contracts on Wednesday. Total Open interest on this option is a measly 214 contracts, and that translates directly into a much wider spread. As of Wednesday's close, the Bid on this contract is $1.55, while the Ask is $2.05. That is a spread of $0.50 vs. a mere $0.10 spread for the MSFT ATM call listed above.

Since we frequently have to buy at Ask and sell at the Bid, this spread must be factored into our risk assessment for the trade. Let's assume that we buy the MSFT calls and later decide to exit the trade due to nonperformance. If the price of the underlying hasn't changed appreciably, the price of the option will likely be unchanged as well. So the option that we purchased for $0.90 should fetch $0.80 when we go to sell, amounting to a $0.10 loss. Conversely, if we go to exit the calls on SPW shortly after entry due to no appreciable price movement, exiting that call option will lock in a loss of $0.50, even though the stock has not yet moved against us. At its inception, any long option purchase will be subjected to a loss equal to the difference between the price paid for that option and what price that option would fetch if we were to turn right around and sell it back into the market. The larger that spread, the larger the risk.

As you can see, looking at liquidity via the spread on an option is just one more piece of the puzzle we need to assemble in our pursuit of trading profits. Hopefully this discussion helps you to better define your own approach to risk management.

Questions are always welcome.

Mark

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