A very nice suggestion. While, I don't presently have the time to share all that I do I will provide some insight into some of the methods I use.
Risk and reward is a balancing act. We need also include probability in the equation. Also, I tend to distinguish between trade specific risk management and portfolio risk management. At the portfolio level, we are typically talking about diversification and perhaps some hedging techniques. For example, if you only trade covered calls your portfolio will be susceptible to a market downturn. That may be okay if you're a long equity investor, but I think you need to question how much of a portfolio draw down are you willing to take. Most people don't do that and saw their accounts decimated by 40% to 50% following the market sell-off at the end of 2008. Imagine if they just stopped themselves out with a 10% loss...
Many of the positions I trade have a relatively small maximum return when compared to their maximum loss (e.g., iron condors). What allows me to make money over the long-term is that they tend to have a high probability of success, which simply means that they win more often than they lose. So, I cannot expect to take maximum losses and remain solvent. So, what I end up with are trades that are "probably" going to be profitable but that will result in losses from time to time. My job is simply to curtail the losses to a level that allows the profits from the majority of trades to absorb the loss while still growing my equity.
The techniques I use vary from strategy to strategy, but let's talk covered calls since that is sort of where this thread started.
The position typically starts with a naked short put being sold out-of-the-money on a stock that has met my fundamental and technical selection criteria. In short, I want a company that is 1.) profitable, 2.) growing its earnings, and 3.) that has a bullish technical pattern. I then ask myself a few questions. The first question I ask is how much can this stock sell-off and still be a moderate to long-term bullish candidate? If the stock falls below that price level it would no longer satisfy my technical criteria, so I want out. The second question I ask is that if I closed the position at that price level what would my exit price likely be? This allows me to calculate an anticipated loss, which then allows me to size the position so that the anticipated loss is limited relative to my overall capital. General advice is to risk no more than 5% of capital, but experienced traders with a meaningful account size will limit that further to 1% or 2%. I am willing to take closer to the 5% loss because these are longer term investments for me and I want to give the stock the room it needs to move in a natural pricing pattern. A successful trade also tends to earn 5% or more on risk capital, so a couple winners will offset the loss and keep me in the game. I have a 70%+ win rate on these, so the probabilities are also in my favor.
So, when I open the short put or covered call position I know that 1.) I am probably going to make money, and 2.) that all I need to do is manage the downside risk. If I am effective in managing the risk and limiting my losses, my account will have no choice but to grow. Here are the basic steps I use to do that...
Assuming I like the trade, I will open the position using a limit order. I then immediately place a contingent order that closes the position if the underlying stock sells off to the level of my defined stop. I place that on a "Good Til Cancelled" or "GTC" basis. This way, if the stock drops in value it's like triggering the ejection seat on a diving fighter plane. The stock has demonstrated that I was wrong and I'm not so much concerned about how I get out so long as I get out.
It's worth noting that the stop is typically below the strike of the short put, so there is a defined price range between the strike of the put and my stop in which I am willing to accept assignment of the stock. If assigned I will hold the stock and probably begin selling calls against it. At this point I have brought in a credit from the put sale and am now bringing in another credit from the sale of the call option. This reduces my break-even point and I then reassess my stop-loss. My immediate goal is not so much to lower the level of the stop-loss, but to ensure that I am comfortable with it. I might move it lower to accommodating a further downside fluctuation, but more often than not I just leave it where it is at. From there on out the game plan is to sell calls against the stock rolling from one month to the next so long as the stock's price pattern does not break down and it is not called away. My stop gets moved up along the way and between price advances in the stock and the rolling premium sales, it is soon at a price level that provides a profit.
I tend to favor solid, established companies (e.g., S&P 100) that pay dividends but will also go after growth stocks. Recent examples include Dow Chemical (DOW) and Nordic American Tanker (NAT) among the dividend paying variety and Research In Motion (RIMM) on the growth side of things. This last year I enjoyed solid gains during the market rally with I believe two positions being stopped out. What made this year particularly attractive for naked puts and covered calls is that stocks were trading at relatively low price levels and options premiums are rather high. Combine that with the rally we saw since March, and it was difficult not to make money with the strategy. This is dangerous because it feeds our greed impulses and we tend to loosen up on the reigns.
Covered calls and naked puts are two of the few options strategies where I use an actual stop order, but I use it for those particular positions because that is what I found that works for me. I have learned not to engage in philosophical or "what if" debates with myself. I make my peace with the trade before it's opened. I know I might get stopped out and take a loss, that I might see the stock rally to new highs while I'm stuck with limited premium, etc. I'm okay with all of the possibilities.
Christopher Smith
TheOptionClub.
--- In OptionClub@yahoogro
>
> Chris calls out the "magic words' below:
> "... the long-term money is made and lost through managing risk. Until a
> trader learns how to effectively manage risk, their trading will
> be marked with painful equity draw downs..."
>
> How's this for a new year's/decade'
> what techniques, rules, principles or whatever do you follow to stay out of
> trouble?
>
> For me it's all about position size and "de-localizing" risk.
>
> with my style, I know I will inevitably grow a trade (i.e. max dollars at
> risk) over the life-cycle of the position. so that means starting almost
> infinitesimally small - I start each expiration cycle with a one-lot limited
> risk spread (usually a long otm vertical). I watch the max risk throughout
> the trade and try to keep things ideally maxed around 1%-2% of total capital
> (though I will undoubtedly blast through this a couple times a year and have
> as much as 20%-25% of total capital at risk on my net positions). The point
> about position sizing for me is that no matter what happens - even in the
> worst case - I can live to trade again. If I am vigilant about position
> size, everything else falls into place: no need to "cut losses short" or
> have any such artificial line in the sand where I admit I'm wrong; I ASSUME
> I'm wrong from the get go by staking and maintaining the position size.
>
> The other real risk management practice I follow is to constantly shift
> where my max risk is a trade or de-localizing the max loss point. I do that
> by shoving the risk away from atm strike - however I can make that happen -
> while still giving myself a chance to somehow make money on the trade.
>
> As Chris notes, there is no all-weather vehicle (strategy) for trading so as
> long as I follow the "nudge the risk away while keeping max risk acceptable"
> practice, I've taken care of business.
>
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