By Mike Parnos, the Options Therapist*
I’m approached for prescriptions on a daily basis. Traders are looking for a magic trading elixir that will cure what ails them -- otherwise known as the Holy Grail of trading. Their portfolio is in crisis. So, where do you start? How about first learning to manage what you have before you start dreaming about what you don’t have?
However, if you’re one of those traders whose portfolio has been up for an extended period of time, you’re no longer the patient. You’re on your way to becoming a doctor.
Principles of Account Management
When you read a recipe requiring a “pinch” of salt, how much is a “pinch?” How much is a “touch” of class? How much is a “modicum” of eccentricity? How about a “slice” of life? What I’m getting at is that certain measurements are subjective and can vary based on the person doing the measuring. The same holds true for account management principles. Account sizes vary and so will the percentages you may choose to use.
Let’s examine a time-tested method for calculating risk based on your account size. I’ll use an account size of $100,000 -- because I like round numbers and I wish I had that much.
Variety Is the Spice of -- Safety
By now, you should know that there is safety in numbers. Two burgers are better than one, and two paper bags are better than one (in some relationships). The point is that you don’t want to put all your trading eggs in one basket because you may end up with an omelet instead of cash soufflé. Diversification will come from using positions on stocks / indices in unrelated sectors.
For instance, we might have one play on the QQQs, another on the BBB (Biotech sector), another on the RUT (Russell 2000 small caps index) and another on the SPX (S&P 500 large cap index).
In a $100,000 portfolio, you only want to risk 2 - 3% of your $100,000 account on each position. Now, how do we figure out what kind of positions we can use? Because those of us in the Options Therapist community primarily use credit spreads, we first need to figure out the maintenance for each position. Let’s check out the numbers on a few of our most commonly used strategies.
Example #1
SPX Iron Condor: 10 Contracts
Bull put spread (10 points)
Bear call spread (10 points)
Premium credit: $2,500
Maintenance requirement: $10,000
Technical risk: $7,500 ($10,000 - $2,500)
On the surface, in a $100,000 portfolio, if you were only able to risk $3,000, that would mean that you could only trade approximately 4 contracts ($3,000 risk). But, although our technical risk is $7,500, we’re never going to allow the position to get to that point. The very most we’re going to allow is a loss of $2,500. That would be a 1:1 risk / reward ratio.
That means we would act if / when it would cost $5,000 to close out the SPX position. We are, in effect, giving back the $2,500 premium we took in plus another $2,500. Our actual loss would be $2,500.
So, if we figure our risk to be a $2,500 maximum loss (as described previously in this article), that $2,500 represents 2.5% of a $100,000 portfolio. Therefore, a 10-contract position of a 10-point spread would be acceptable.
Example #2
Low Risk Straddle -- DELL @ $35.60: 10 Contracts
Buy August $35 puts ($1.60) and calls ($2.40) for a total of $4.00
Technical risk: $4,000
As my therapy patients know, when we put on our “low risk” straddle, we anticipate a large move to happen within the first 30 days of having established the position. If this doesn’t happen, we’re out of the position in 30 days. The amount that the August $35 puts and calls will erode in the first 30 days may be 10 - 15%. Therefore, if our $4,000 technical risk erodes away by 15%, we’re actually only risking approximately $600 ($4,000 x 15%).
With a real risk of only $600, we could theoretically trade 40 contracts, and our risk would be $2,400 -- well within our 3% maximum money management figure.
Don’t confuse the actual amount risked with how much money will be tied up in the trade. In Example 1 (SPX), even though we’re only risking $2,500, we are tying up $10,000 in maintenance. In Example 2 (DELL), we are actually tying up $4,000 in the trade, even though our risk is only approximately $600.
Stocks -- A Slightly Different Game
If you are buying stocks, the method of calculating your risk is basically the same. You simply have to calculate how many shares you can buy and stay within the 3% risk (on your $100,000 account size) parameter.
Example: NTAP is trading at $20.00.
You have to determine where you will place your stop. Let’s say you expect NTAP to move up, but you’re putting a stop loss at $18.50. You’re willing to accept a $1.50 loss if you’re wrong about the direction of NTAP.
If you’re limiting your loss to $3,000 per trade, you could buy 2,000 shares of NTAP. That’s figured by dividing $1.50 (your acceptable loss / share) into the $3,000 (maximum acceptable loss). You would actually be tying up $40,000 on this trade, but your risk would be only the $3,000.
The Most Important Requirement
The common denominator to make the previous examples valid is the assumption that you have self-discipline. Without the ability to take your loss at the predetermined point, calculating your money management parameters is like spitting into the wind. Whether you use mental or physical stops is up to you. I hope, by now, you know (and can deal with) your limitations.
