Option Investor

Option Writer Portfolio Additions

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This market has so far proven the importance of risk management. Risk management (RM) consists of stop loss parameters that meet each individual’s tolerance for volatility and investment objectives. RM also refers to what percentage of assets is allocated to selling options in low and high volatility markets. In order to generate consistent risk adjusted returns, I adopted a policy of increasing the number of positions in low volatility markets and reduced the number of positions in period’s higher volatility. You can also adjust the position size per position to reflect the current or implied risk level. For instance, if your average position size is equivalent to $20,000 per position then higher volatility levels would adjust the position to $10,000. I prefer to set dynamic position sizing that adjusts according to the $VIX.

It should be noted that position sizing can reflect the nominal value (assigned value), the number of contracts and the initial margin requirement. I prefer to set the position size relative to the assigned value. It acknowledges the worst case scenario. For example, you have $250,000 in your option writer allocation. If you chose to be aggressive you may set your position sizing to reflect buying $500,000 of stock in the worst case you were assigned on every stock. If you suddenly became bearish, you may choose to only expose your portfolio to a $125,000 assignment. For those of you that prefer to set your position sizing by the initial margin, you need to make sure that there is sufficient capital to meet the changing margin requirement. Some of you may be new to writing option. If you are, you should know that the margin requirement is calculated by multiplying the price of the stock by 20% and adding the current premium. Most firms provide a credit for being out of the money, but you should go with the more conservative requirement in order to keep some “powder dry” for potential opportunities or trade adjustments. Some of you just sell the same number of contracts as a way to remain “share weighted” rather than dollar weighted. Being share weighted can overexpose you to one stock or sector.

I am looking at this dip in the market as an opportunity to write some out of the money puts. Now that there has been a bounce, there is a defined low on many stocks and indices to set our risk management levels. We can use technical stop losses (my preference), amount risked stop losses and strike price related stop losses. The later can include a stop on a breach of the short option’s strike price or the cost basis of the stock if assigned. Unless we are looking to be assigned the stock, strike price related stop loss parameters don’t usually provide any consistent reason to exit the position. A technical stop loss or amount risked stop loss gets us out of the trade for a reason. Technical stops are initiated when a support or resistance level is breached. Depending upon the level of the stop and time until expiration, the position may win or loss money. Our goal is to have 70% success. This market hasn’t helped us achieve those results. I will try very hard to get the probability numbers higher. Because I don’t know your risk tolerance, my stop loss parameters might be too aggressive. Don’t wait for me to tell you when to exit. I normally set the risk management levels at the time I set the entry target. Knowing how much I can lose helps determine how much I am willing to risk to attempt to gain. Good trading to all.



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