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Option Trading and Risk Management - What Approach Do You Use?

Posted by Pete Stolcers on June 19, 2008

Option Trading Question

"I noticed you haven't written much about Money Management as a critical element to trading effectiveness. Do you personally apply a specific Money Management philosophy and if so, can you provide your perspectives on which is most effective. Additionally, I've read some about Fixed Ratio Money Management, made known by Ryan Jones' book, 'The Trading Game'. Do you have a perspective on this? Ryan seems convinced that Fixed Ratio is the most effective method out there to maximize gains while managing risk."

Option Trading Answer

Money management is important because it allows you to control risk (emotions). When I started trading I could have saved myself a lot of heartache by having a system in place - but I didn’t.

My method has evolved over time. I read my trade logs (and still do) and I learned from my mistakes. I incorporated my findings into my trading and I don’t even think about it now.

I tend to stay away from anything that is rigid and I prefer to be very fluid. After years of trading, it suits my personality. Consequently, I tend to write about the different strategies and mindsets I have during various market scenarios.  This is the day-to-day thought process I go through.

Traders that are managing money (or trading for a firm) can’t get away with my approach. The Risk Managers want specifics and they watch for deviations. They have specific rule sets. When I traded for a fund, I felt handcuffed. I understood why they had measures in place. There were times when it kept me out of trouble and there were times when I wish I had the latitude to spread my wings.

I haven’t written about a risk management system because I use different option strategies to control risk. When the conditions are uncertain, I scale in and sell premium so that I’m distanced from the current action. I also maintain a long/short portfolio so that my market risk is reduced. I also use less capital until a trend reveals itself. There are many more examples and tactics that I use. 

When my confidence is high and I have a strong bias (trend), I buy premium and I am willing to increase my size.

If you read my series on “v" bottoms, you’ll have a better idea of how I control risk by shifting my strategies. I also have another article where I discuss hedging option positions during a swift decline like we had in February. When the market is in a transition, I like to get to a cash position. That allows me to build my portfolio and to see things objectively.

I also disclose my current trading strategies in my Daily Stock Option Strategy section. In the last few weeks I have been short OTM call spreads on regional banks, restaurants and retail. I was not convinced that the SPY would breakout above SPY 144 and this strategy helped me control risk and make money as the market rolled over. 

As for Ryan’s book, I have not read it. Feel free to leave a comment on it or any other worthwhile read.

Option Trading Comments

  • On 05/23, Gemma C said:

    If your portfolio manager had taken an underweight position in a sector of the index which has been exhibiting many of the characteristics of a bubble. If you were to create an overlay portfolio which would enable you to gain exposure to the sector should the rally continue, what sort of call option strategy would you undertake?

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