In my article “The Beauty of Planned Capital”, I mentioned the trader who reported his profit by completely ignoring his potential risk. I’m sure that everyone reading thought, “Geez, what a goof! I’d never do that! I know MY risk!”.
Hooray for you! I hope so. But…I keep hearing people say things that make me wonder, such as:
- “My maximum risk is only X because I set my maximum loss equal to what I make in a month.”
- “My maximum risk is only X because I’d never let it get that far before adjusting or closing the trade.”
- “My maximum risk is only X because I have a stop loss order set.”
Or my latest favorite:
- My maximum risk is only X because [fill in your favorite underlying] has NEVER gapped more than Y points overnight.”
Options have a reputation for being incredibly risky. While the fact that they are decaying assets certainly adds to their risk profile, the truth is that they are perceived that way because most people don’t understand their real risk.
I certainly didn’t.
When I first started trading, I traded RUT butterflies and OEX calendars. I knew that OEX was American-style but everyone told me that getting assigned early wasn’t a bad thing because it meant that you got to keep the full time premium. But conventional wisdom has a way of being conventional but not always wise.
Early assignment works perfectly fine with equities. If your short option gets assigned, you end up with replacement stock, either short or long. So if you had short puts that got assigned, your 90-some delta puts got replaced with 100 deltas of stock. No big deal.
Ah, but what about cash-settled indexes? Your 90-some delta puts go away, leaving you with… cash. And a position that is now way outside your delta limits. Here’s a hint – if you got assigned on those, it’s probably NOT because the market is about to go screaming down. It’s because the market maker needed some long deltas for tomorrow’s expected meteoric rise and took yours.
In my case, I had a lovely call calendar that SHOULD have been a fantastic trade. I woke up one morning only to find that my short calls had been assigned and I was now about a gah-zillion long deltas just as the market was screaming down.
Bye-bye, maximum loss! We’re WELL past that point now. Happily, I was trading small so I was able to handle the loss but it was “an excellent learning experience that built character.” (That’s my story and I’m sticking to it.)
What else could cause a trade to exceed maximum loss? If you’re trading in expiration week, you can get a false sense of execution prices by looking at mid. The reality is that if you’re trading near expiration, mid points mean absolutely nothing. You’re potentially going to hit bid/ask on each individual option.
Stop losses are great but, in a flash crash, execution price may be WAY off “reasonable.”
What else? Oh, yeah, we’ve all recently had a reminder about the overnight gaps in RUT. Up until last August, the largest overnight gap in the RUT was $17.29 on October 23, 2008. Then came August 21, 2015 when it gapped an eye-popping $37.03!
And this assumes that you’re still able to trade. What if you get, well, let’s not say hit on the noggin by a meteorite, but how about if you’re notified that your great-great aunt left you her multi-million-dollar estate and you have to get to the attorney’s office RIGHT NOW or it will be forfeit. And your $100k ROCK trade is getting near maximum loss. Are you going to stay and try to close it, or will you go get your millions? Of course you’ll go.
So what’s your real risk in the trade? The total amount of money you can possibly lose. It’s that simple. That’s why one of John’s first rules is never to trade more than 20% of your total capital or the amount you can afford to lose, whichever is smaller. I hope you stay healthy, that you avoid meteorites, that you have no emergencies, that all your adjustments are timely and that the market doesn’t do something completely unexpected.
BUT…if something DOES occur, let’s all keep our losses manageable by knowing exactly what the real risk is.
Written and contributed by Cynthia Sarver