As our February Gold Class prepares to take their last class on portfolio risk management, it caused me to take pause. Good risk management can mean many things to many people.
Some consider risk management the process of managing winners and losers. If they have an iron condor, butterfly, calendar, or any host of trades, and traders keep their losses to a minimum and take off winners that is proper risk management.
Others consider it having high acumen in adjusting options trades. If a trader can convert a single butterfly, into a double, triple, or even quadruple butterfly, that is good risk management.
Some would consider risk management, more risk mitigation. Traders that are buying cheap out of the money puts, in case the market blows up, are mitigating risk.
While I agree with parts of all of those theories, they all leave one major thing out. Good risk management means taking the right calculated risk. While it sounds simple, most traders do not take calculated risks; they try to trade systems…something risk management does not lend itself to.
Does this mean that a trader with a system doesn’t manage risk? No, not at all. The best system traders have very strict risk management metrics. The problem is that most traders have a poor system of trading. A poor system of trading means:
- Robotic Entry
- Little evaluation of market conditions
- Reliance on ‘adjusting’ out of problems
- Involve ‘throwing capital’ at a problem
- Little evaluation of the trading system itself
- Seems easy
Here is the thing, trading is a huge pain in the rear end. It’s something I love, and I enjoy trading, but that doesn’t mean it’s easy. A good trading system needs to have constant evaluation of what is going on around it in order to do one thing: maximize return by using as little dollars as possible to make as much money as possible. They evaluate volatility conditions of the market, the stock or index, along with the fundamentals, technical’s, and momentum in the overall market. This means:
- Strong reliance on volatility evaluation
- Good Risk/Reward
- Favorable Trade Structure
- Smart adjusting that REDUCES capital in trade (and usually open contract)
- Buying AND selling of options
Even those that use options as a defacto for the stock market and trade directionally should be using the bullets above to put on their trades.
The problem is that most traders don’t even know how to start evaluating volatility conditions. The good news is that I am here to lend a hand. The steps to evaluating volatility are as follows:
1. Understand the Cause of Volatility in your instrument
2. What is ATM Implied Volatility
3. What is the Curvature of the Skew (how pricy are calls and puts)
4. What is the current Term Structure
By walking through those 4 bullets on every trade, traders will soon be able to quickly survey a stock, index, or commodity to know whether conditions are good. If a product is new, then the trader may have to go back and look at what ‘normal’ conditions are for a product. The good news is, that like the VIX, all of the above (sans No. 1) revert to a mean…there is, in every optionable product, the existence of cheap and expensive volatility.
By incorporating this, traders will soon find faults in their trading system, or confirm its reliability. It will also help traders avoid pitfalls of a system, such as the ‘blow up.’ It’s always sad when a trader puts a trade on month after month, only to have gains wiped out in a week. By evaluating volatility conditions, it will help traders see why their system works, and possibly, when it doesn’t. This could get traders out of the market when things are unfavorable. And, if one thinks about it, the best way to manage risk is to avoid risk when it isn’t worth taking.
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