Gamma. Ahh, the greek that doesn’t get a lot of love. I think it used to date the “VCondor”. Enough gossip. As we know, high gamma trades (ie. the Bearish Butterfly) carry high returns. Since nothing is free, it also moves more; thus, it can be argued that it’s riskier. So, let’s address this concept of risk.
Here’s risk from Red Bull’s perspective titled “The Most Adventurous Year Yet”. This will get the blood pumping.
Discovery.com sums it up best when looking at wingsuit / BASE jumping:
While the fatality rate for wingsuit jumping is hard to calculate (the number of deaths are tracked, but not the number of jumps), a 2012 study of BASE jumpers reported that 72 percent of jumpers “had witnessed death or serious injury of other participants in the sport, 43 percent (of) jumpers had suffered a signiﬁcant BASE jump injury, and 76 percent had at least one ‘near miss’ incident (an incident which would most probably result in serious injury or fatality but was avoided),” study author Dr. Omer Mei-Dan, a BASE jumper and sports medicine doctor wrote in his textbook, “Adventure and Extreme Sports Injuries.” Source: http://news.discovery.com/adventure/extreme-sports/wingsuit- diving-too-risky- to-master
All of that above info sure makes you want to go out and jump off a cliff, doesn’t it? 3 out 4 of your buddies are dead or injured? What?
All in all, risk is a relative term. We all have a different view as to what risk means for us given the situation. A couple of weeks ago when I spoke as the guest speaker in Dallas for an undergrad derivatives class, I was asked something that hits home on this topic. One of the students asked: “If there is one thing you could share with us today that you didn’t know when you started trading, what would that be?”
My response was one word…”risk”. When I first started out trading, I knew managing one’s risk was important, but I didn’t know how important. I just thought it was one of those items on the trading checklist. There are many items that are essential to successful trading, but if you don’t get your risk nailed down it may be a bumpy ride. I’m sure if you were going to jump out of a plane, you would put “pack the parachute appropriately” at the top of the list.
For those who have kids, here’s one for you. New traders are like a toddler. When they see something they want, (ie. profit for the trader, chocolate for the toddler), they focus on that and nothing else. If they don’t get it, well, they will let you know. I’m not saying new traders will scream their head off until they wet their pants, but we all remember starting out. I know some of those early trades sure made me pucker up.
So, what do I do with my “risk management”? Two things: entry and drawdowns.
Entry: I find trade size is key when it comes to risk management and that is done at entry. I told the class that 500 shares of SPY are the same as 1 /ES mini (futures contract). Some folks may think that futures trading is “risky”. It really isn’t. It’s all about size. With $100,000 and SPY trading at 200, you could spend your entire amount on 500 shares of SPY or just buy 1 /ES future for about $5K and use the rest as a hedge.
Drawdowns: As with any high gamma trade, the reward is higher but it moves. When it moves in the wrong direction, you get drawdowns. There are many ways to measure and group a particular strategy’s performance (sharpe ratio, etc). Just keep it simple and check the drawdowns after the strategy was appropriately back tested. This is why I think it’s more important for one to back test their strategies themselves rather than hire a 3 rd party to do it. You will immediately see how your trade and stomach will handle some of these wild market movements. Imagine trading it with real money?
Last year I traded differently than this year. Why did I change? One reason…drawdowns. If I find another strategy with similar returns but with a lower drawdown component, I will jump on that new ship. Yes, we traders are a fickle bunch, but I think it’s the key to success.
So, when you want to step up and put on those big “gamma” pants, just keep that risk in check.
Written and contributed by John Wilson