Principles of Risk Management

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Clare Daniel
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1 Principles of Risk Management The Option Pit Method Option Pit

2 What We Will Discuss What is Risk Management Where to Start with Risk Management Money Management: Money Plan Portfolio Management: Trading Plan Position Management: Trade Plan Portfolio Insurance

3 What Is Risk Management?

4 What Is Risk Management My Definition for Option Traders: The taking of risk in the most capital efficient manner as such to receive the highest possible return for the fewest amount of dollars Great But How???

5 Understanding Risk Before flying a plane, pilots must go through extensive training as to how the plane actually works Then pilots must do extensive time in a simulator Why? So when they are flying they are prepared for what could happen and why it is happening

6 Where to Start Understand the Instrument How is a future different from an equity How is an option different from a future Learn the workings of that instrument intuitively What does this mean????

7 Options How does one read an options quote How do options price How do option synthetics function How does the pricing model work How do the greeks function as an output of the pricing model What are the non-modeled risks of options?

8 Why do you need to Know Theory? Charts are nice, but they are built on a models If one doesn t understand how the model works, one cannot accurately manage risk It is annoying, but save the short cuts for later, learn this stuff Understanding the cause of risk is key to managing risk

9 One More Thing Understand the contract you are trading What are the dollars at risk What is the multiplier What does it expire into When does it expire One would think that this is simple: is it?

10 Money Management Once the trader is actually ready to trade, the next step is to build a money management plan A money management plan will allot for how how much of an account will be engaged in the market and how that money is allocated as it is engaged

11 Money Management What kind of money do you have to work with What is the goal rate of return How can you allocate capital so that you are able to achieve that rate of return Can this be done without risk of blow up Is the plan efficient Does the plan scale

12 Capital Different accounts warrant different approaches to trading Do not treat ANY capital lightly All capital is a part of building success and wealth There is no such thing as throw away capital Treat every dollar as if it matters Its only a $6, account

13 Things 6000 Will Buy

14 Return Be aware of what is a realistic rate of return Is 5% a month a realistic number? Compounded that equates to 80% a year Is 2% a realistic return? Compounded that equates to 26% return Traders BE REALISTIC Having the right expectations will help the trader avoid making silly risk mistakes

15 Allocate Capital How much of account should stay in cash What is the target return on traded capital to achieve the trader s goal rate of return Ceteris Paribus- how should capital be allocated into each trade to achieve target rate of return Assume the same target rate of return for every trade Allocate trading capital across trades

16 Risk of Blow Up When allocating capital, one common mistake is the too much of a good thing approach Traders need to be diversified Aware of the risks of their long/short premium Aware of maximum loss in catastrophe Take appropriate steps to ensure the one is always able to trade Never be short units

17 Evaluate the Plan Once the money management plan is in place, make sure to evaluate the plan after its completion Is there too much concentration on one short premium spread or another What is the net Vega exposure Is there enough long realized exposure Is there enough cash Is there enough insurance

18 Is It Scalable This is the key question in a money management plan A real trading approach should be planned for 200,000 not 20,000 dollars this is why it is so important to be a realist If it doesn't scale, it doesn t work Many retail traders take FAR bigger risks with small accounts because they don t think scale

19 The Trading Plan This is the nitty gritty of our capital allocation Assumes all trades are in tradable, but not spectacular conditions Allocates trading capital to each trade in the plan Adjusts size of trades according to conditions in the market Put into place restrictions on losses and target gains Covers adjustment strategies and insurance

20 Trading Plan Finally, adjust allocation according to what trades are more or less favorable If butterflies are statistically more favorable than time spreads, do more butterflies If condors don t look good, don t trade them Cash is OKAY sometimes

21 The Option Pit Method On the trading floor, the trades come to the trader With each trade of one particular type the trader needs more and more edge Premium sale Premium purchase With each trader that has more edge, the trader increases the size of the trade slightly

22 The Option Pit Method As a trader becomes more or less short premium the trader is willing to accept less edge to take the opposite trade I am long a lot of premium I will sell premium at a discount I am short a lot of premium, I will pay up for premium Greeks are traded to offset each other

23 The Retail Trader The retail trader does not have trades coming at him or her. But the retail trader does have edge The ability to initiate EVERY trade should have perceived edge in it These options are too cheap These options are too expensive

24 The Retail Trader Each successive trade should be better than the last when it is adding to greek risk A trader that has a lot of short premium, needs to A LOT of perceived edge to sell more premium Traders should ladder higher 1 st trader should be about 1/3-1/2 the size of final trade in a direction Unlike a market maker, dollars used should be capped to any trader or name

25 Retail Trader As a trader builds greeks, he or she is actively looking for trades that take the other side I am long a lot of delta, I am going to look for trades that have edge that get me short delta I am short a lot of vega, I am going to look for trades that have edge that will get me long vega

26 The Method If executed properly, the trader should be able to carry a NET portfolio that has little systemic risk The portfolio will have low NET greeks Each position will have greeks though If we can limit risk to company risk and away from systemic risk, trading for edge will be profitable Assuming you know how to find edge

27 Things to Remember You need to learn how to capture edge You need to learn how to weight greeks Use capital weighted Use beta weighted as well This can be commission intensive Require slightly more active management To be a job requires several hours a day Requires STRONG understanding of Option Fundamentals

28 Most Important Thing Gamma and Vega are the most important greeks to monitor in any approach Theta and delta will handle themselves Be aware of how the greeks change with underlying prices A balanced portfolio can change on you Learn to Trade VIX derivatives They have the most edge

29 Managing the Book Trade 1: Sell Iron Butterfly rated 3 (out of 5) Trade 2: Sell Iron Condor Rated 3 Trade 3: Sell Iron Butterfly rated a 4 What should the trader do for Trade 4 Trader can: Buy a Straddle rated a 3 `Sell an Iron butterfly rated a 4

30 In the End The Option Pit Method is a trading plan, that isn't a trading plan. It states Put on good trades for edge As a portfolio takes on risk look for trades that take the other size Manage each trade on its own Practice EXTREMELY tight risk control Manage the portfolio greeks ABC: Always Be Closing

31 The Benefit You can sleep at night Risk will be lower Trade duration will be shorter You will likely be profitable You can be wrong ALOT

32 Trade Plan What is the most important part of managing the risk of a trade? Picking good trades!!! Good trades make risk management easy How does one enter good trades? Take the time to understand what are the best conditions for each trade Build an adjustment plan

33 Keys to a Trade Plan Write up the optimal conditions, normal conditions, and no-trade conditions Write up an adjustment plan for any potential conceivable move Underlying rallies, IV down and falling Underlying rallies, IV up and rising Underlying falls, IV is up but falling

34 Trade Plan Set a maximum loss for each trade This is the level the trade is pulled Set an absolute max loss for each trade This is the level that a trade will never be allowed to fall to under any reasonable scenario For a condor, maximum loss might be same as the target profit ABSOLUTE maximum loss might be the total cash equivalent

35 Why 2 Max Losses One of the hardest things for traders to deal with is when a trade is down, but not at maximum loss Typically, they will not adjust or stay in overnight If Absolute maximum loss is within one standard deviation, the trader should adjust regardless of max loss Saves traders A LOT of money

36 Keys to Adjusting For every trade there is likely some variant of adjustment that is going to work well However, there are some important keys to adjusting that will help insure that ones account doesn t blow up We see more blow ups from bad adjusting than bad trades Close cheap shorts, always

37 1/3, 1/3, 1/3 Rule Set Max Loss When you are at 1/3 of max loss make an adjustment to reduce risk When you are at 2/3 of max loss make a second adjustment to reduce risk When you are at 3/3 of max loss KILL THE TRADE!!!

38 Adjusting Never throw capital at a trade The idea that simply adding a butterfly or a calendar is a solution is wrong Rolling and increasing size is also typically a mistake Try to add as little capital as possible Keep return targets and maximum losses off of original trade, do not add in the adjustments Never open up a cheap option Try to stay contract neutral

39 Insurance Traders need to know how to protect themselves never be NET SHORT teenies or units Be able to trade the next day, always be able to do more

40 Summary There is a lot of keys to risk management it starts with knowing what you are trading intuitively It then moves into a money management plan, into a trading plan, and to a trade plan

Thank You Contact: www.optionpit.com info@optionpit.com 1(888) Trade-01 Find us: www.facebook.

41 Thank You Contact: 1(888) Trade-01 Find us: Take our Gold Course for 15% off the retail price of 1950, call or us for details

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