Short Option Risk Management
When trading short options, there are a few different methods to apply risk management to one's positions. The proper one may differ depending on the position and the probabilities of profit and loss. Another variable is each individual's risk tolerance. The following are the four Risk Management techniques we will be using with the Option Writer positions.
Strike Price - Setting the stop loss at the strike price is the most simple and least dynamic. This method is useful since we are trying to sell option premium for cash flow purposes. If the share price closes below the strike price on or before expiration, you will be assigned the shares. Getting assigned shares is a great way to accumulate a core portfolio or a covered call/put position. But it is a great way to diminish your short option trading allocation.
Cost Basis - This too is simple yet it gives the price of the underlying room to go into the money by the amount of premium received. For instance, you sold 10 XYZ Puts at $0.80/contract at the 30 strike. The cost basis is $29.20. Therefore, if the stock drops below $29.20, the position is at a loss on expiration. If you are assigned, you pay commission twice. Once on assignment and again to close the stock position. Say for instance the shares on XYZ slip below $29.20 to $29.05 in the last remaining minutes on expiration Friday. Since the option has very little time premium, the price amount above the intrinsic of $0.95 is pure supply and demand. If you buy to cover the short option, you may need to pay the offer price.
Technical - Utilizing techincal analysis levels for exit level is the next level of dynamic risk management. While the stop loss price may be fixed initially, the price patterns that may develop over a month can provide a refreshed view of support and resistance levels from both price and moving averages. So far, we have been fairly simple with the technical analysis so as to relate to a larger audience. Going forward, I will be using Stochastics, RSI, Volume and ADX. The use of technical analysis is difficult because our tolerances and inputs may be completely different than yours. However, the use of price support levels and popular time frames such as the 50 and 200 day moving averages can help get us all on the same page.
P/L - The most dynamic risk management technique utilizes a multiple of max profit (initial premium) to determine the stop loss level. We will be using a multiple of 1 unless otherwise noted. The amount of stop loss isn't dynamic but the price at which the stop loss is determined . Because of the option's various pricing variables, such as time value, delta and volatility, the price in which the stop loss is triggered may differ from each day. For instance, we sell 10 put options for $1.05. The max gain is $1,050. The stop loss is set at $2.10 per contract or a loss of $1.05 per contract. Depending upon the position's delta and theta, the stop loss may be $3.50 point lower today and $3.60 points lower tomorrow. While this method is the most difficult to follow, it is also our favorite. The position size determines the amount of assumed risk tolerance on each position. Therefore, the amount of loss should be reflective of the amount of potential profit.
The above risk management suggestions may not work for everyone. Sometimes, we like to rely on multiple risk management techniques or give a position a little more room. The tendency is to use end of day price levels rather than intra day signals. We will begin to display the top three risk management levels from now on. We will try to stay on top of the P/L stop and alert intraday. A revised list will be sent out later today outlining the stop loss prices for each parameter.