There are two main parts to every trade. The first is setting up and placing the trade, and the second part is to manage that position once it has been placed. Far too many traders emphasize the first part and disregard the second part completely. When, in fact, to be successful in this industry it is far more essential to be able to manage your positions.
When dealing with options, there are many ways to manage positions. Managing winners can be as difficult if not more difficult than managing your losers. Most new traders will cut their winners short to lock in gains and let their losers run in hopes that it will turn around (recipe for disaster). Options give you the freedom to make adjustments along the way. Adjustments are the more difficult part of managing options because there is no one correct method, no one size fits all. Position or even portfolio management does not stop there, however, there are still ways we can protect our portfolio from a significant market downturn. First, we are going to discuss why risk management is important; then we will take a look at what units are and how we can use them in our portfolios.
Why Is Risk Management Important
No one is going to win 100% of the time it's as simple as that. In trading, you have to have a plan for the good, when to take profits, and the bad, when to cut losses.
If you lose 10% of your portfolio, it takes an 11% return to breakeven.
If you lose 25% of your portfolio, it takes a 33% return to breakeven.
If you lose 50% of your portfolio, it takes a 100% return to breakeven.
If you lose 75% of your portfolio, it takes a 300% return to breakeven.
If you lose 100% of your portfolio, you are done.
Once you begin the slide, it can be hard to fight your way back out of it. Risk management is important because it keeps us in the game for the long-term. Trading options is not a sprint but a marathon. All traders have rough patches, and traders take on losses.
You never want to place yourself in a position to lose your whole portfolio if something goes wrong. Luckily with the right preparation and trading plan, we can mitigate our risk. Options give us several choices of risk management: position sizing, adjustments, diversification, spreads and through position or portfolio insurance.
What Are Option Units
Have you ever noticed those deep out of the money put options at the bottom of an option chain? Those are known as 'units.' They are the cheap puts that sit around not doing anything until something wrong happens. When that happens these little puts come to life surging in value 400%, 500%, 1000%, etc.
When looking for units, you want to start at options with Deltas between 2 and 5. This means for an average priced stock the option will be worth $0.25. These are the options that are built for insurance. They will sit around at approximately the same value until it comes time to explode in price. If your stock or the market doesn't drop, they will just fade away from your portfolio.
Before you rush off and put these options in a simulator, we need to talk about option models. Option models, like Black-Scholes, are horrible at measuring the extremes. They are great for at the money, slightly in the money, and somewhat out of the money options. The further you get away from this mean the less reliable they become. So the models for these options are useless. They have a tough time trying to predict and track the movement and output the Greeks.
When To Protect Your Portfolio
Not all portfolios need insurance. If you are long a call or long a put you would not require insurance. These strategies have built-in protection where you only lose the max debit that you paid. Similarly, if you are a short-term trader such as a day trader, it would be useless to protect your position or portfolio. The portfolios that benefit the most from insurance are long stock traders and short option traders.
If you are holding stock, especially for the long term, you can protect your whole portfolio or the individual stocks with the purchase of units.
The traders that need to focus on using insurance are short option traders. Short option traders typically collect small credits for a bigger risk. They are okay with this because they are rewarded with a higher probability of success in their trades (typically).
Portfolio insurance is a lot like real insurance. If you wait until it's too late before buying, then it's too late to buy. Don't try to buy flood insurance during a big storm. Don't wait till the stock move against you before buying units. By then the price has already gone up, and now you are just throwing money away. It is a small price to pay to purchase insurance when you place the trade.
How To Protect Your Portfolio With Insurance
A short option trader needs to sacrifice at least 5% of the credit they are collecting to pay for insurance. This is a small price to pay for the level of protection it affords. At the most extreme you could use 10% of the credit you are collecting but keep it closer to 5% will work.
If you are protecting a position, then buy your puts in that underlying for the same expiration. If you are running multiple positions that roll in and out as we do at The Option Prophet, then you can buy puts on the overall market, S&P 500.
If you are protecting a position, you should use the same expiration month for your insurance. If you are moving in and out of a lot of positions, then you could go 3-6 months out for your insurance trade.
Let's look at an example using the S&P 500 for insurance. If you were running a heavy short option portfolio in 2015, you could renew your insurance every six months. In June, while the S&P 500 was trading at 2111, you bought December 19, 2015, 1400 strike puts for $4.00. Those puts had a delta of 2.57 and were 33.6% out of the money.
On August 25, 2015, when the S&P 500 dropped 12% those puts were now worth $18.00, a 350% increase in price. That is the power of units.
When To Close Out Your Insurance
The key to remember here is that insurance is used to protect your portfolio in a major market meltdown. You are not trying to cash in and make a lot of money on your insurance, even though that is nice. The first thing to note is that insurance is there for a substantial drop in the underlying or market. A 5% drop shouldn't trigger your insurance or the desire to close it. You want to hold your insurance for a +10% drop. It is there to protect you so let it do its job and don't close it out too early.
Ideally, when trying to close out insurance, you have to be a bit subjective. Only you will know how much loss you can withstand and where you think the market will go. The one thing you cannot do is predict a bottom. When the market is in a heavy sell-off, you won't be able to tell what is coming next. What you need to do is look at your portfolio and if you are breaking even on your trades and insurance go ahead and close out everything. If you are looking at your portfolio and see a gain, then you need to close everything out. Don't get greedy here.
If you want to remain a trader in this market, you need always to be thinking about the long-term, and that includes sustainability. Your ability to ride through the waves in the market and come out the other side is one of the most important lessons you can learn.
There will always be 'black-swan events' and news that you can't account for. Be smart in protecting yourself and portfolio by buying insurance when you put the position on. Short option traders, especially, need to look at using 5-10% of their credit to buy insurance.
If the market or your underlying drops 10% your position should break even. If it falls 20%, you should be making money with your insurance.
How do you protect your portfolio and positions from a downturn? Tell us in the comments...