MANAGING RISK - AN AGILE OPTIONS STRATEGY

Introduction:

The Federal Reserve induced Q4 2018 sell-off and the COVID-19 was the black swan event are recent reminders of why risk management is essential. COVID-19 caused the major indices to drop over 30% over the course of 22 days, the worst since the Great Depression in terms of breadth and velocity of the sell-off while inducing extreme market volatility that hasn’t been see since the Financial Crisis.

Although option trading provides a margin of downside protection and a statistical edge, when hit with a black swan event, no portfolio is immune from the wreckage. Thus, proper portfolio construction and optimal risk management is essential when engaging in options trading to drive portfolio results. One of the main pillars when building an options based portfolio is maintaining ample liquidity via holding ~50% of one’s portfolio in cash. This liquidity position provides the ability to rapidly adjust when faced with extreme market conditions such as COVID-19. An agile options based portfolio is essential and the COVID-19 pandemic is a prime example of why maintaining liquidity, risk-defining trades, staggering options expiration dates, trading across a wide array of uncorrelated tickers, maximizing the number of trades and selling options to collect premium income is one key to an effective long term options strategy.    

Risk Management and An Agile Options Strategy:

Risk management is paramount when engaging in options trading. A slew of protective measures should be deployed if options are used as a means to drive portfolio results. When selling options and running an options-based portfolio the following guidelines are essential:

  1. Be an option seller to collect premium income while taking advantage of time decay

  2. Set the probability of success (delta) in your favor (70%, 85%, etc.) to ensure a statistical edge

  3. Manage winning trades by closing the trade and realizing profits early in the option lifecycle

  4. Sell options in high IV Rank environments to extract rich premiums

  5. Sell options on tickers that are liquid in the options market

  6. Maximize the number of trades to allow the expected probabilities to play out

  7. Appropriate position sizing / portfolio allocation to manage risk exposure

  8. Sell options across tickers with ample sector diversity

  9. Keeping an adequate amount of cash on hand (~25% - 40%)

  10. Risk-defined trades (put spreads, call spreads and iron condors) 

Cash Flexibility:

Holding 50% cash as a protective measure is essential when faced with unpredictable outlier situations such as COVID-19. A cash position this high is possible because options are a leveraged vehicle thus minimal amounts of capital can be deployed to generate outsized gains with predictable outcomes. Even deploying all the protective measures outlined above won’t offer the protection required during a black swan event. During these black swan market meltdowns, all sectors and stocks homogenize and naturally correlate together in a downward spiral. Cash is the safest way to immunize a portfolio from these types of market crashes. This cash position also provides optionality to go long stock in high quality names when faced with extreme sell-offs.    

Maximizing Trade Occurrences:    

I trade at an expected probability of success of 85% (Delta of 0.15) and in high implied volatility environments where rich premium income can be realized while risk-defining each trade. Given enough trade occurrences, the expected outcomes materialize over the course of time and various market conditions. Placing only 10 trades or 50 trades over a given time period is simply inadequate for an options-based approach. Trading through all market conditions at a specific probability of success level, given enough trades and time, the probabilities will reach their expected outcomes. To achieve the expected probability level, hundreds of trades need to be placed and closed before the probabilities really begin to play out. As these trade data grow in size, plotting all of your trades over time, you’ll see the numbers align more and more with your expected probabilities. Taken together, trade as often as you can at your desired probability of success to achieve the win rate of interest.

Noah Kiedrowski 
Founder of stockoptionsdad.com
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