Making Good Risk Management Decisions

Mark Wolfinger discusses Risk Management with A Concerned Rookie

A Concerned Rookie:

I was short a RUT call spread 830/840, expiring in July. RUT was at 765 only five days ago and yesterday it closed at 818. The trade began as an iron condor and I had already paid 10 cents to close the put spread. Last week, I could have paid 35 cents for this call spread, locking in a very nice profit.

Yesterday I covered that same call spread by paying $3.05. I was concerned that my losses could have become significantly larger.

Did I do right thing? What should I do to prevent such disasters – or do you believe that "no one can predict tsunami?”

I have lot to learn in risk management.

Mark’s response:

Hello CR,

The difficulty that we face is that we must make decisions on any position in our portfolio. Theoretically a decision is required every second of every day, but in practice, we must decide - at least daily - do we want to exit or hold today?

The decision is sometimes difficult to make.

Yes, you did the right thing for YOU. I strongly believe that taking care of risk is a trader’s top priority. And we accomplish that by reducing imminent risk (such as you faced), by trading appropriate position size, and by protecting profits.

Regardless of whether the markets move higher or lower from here, you still did the right thing. Risk management does not involve looking back and questioning your decisions. Instead, it involves learning how to make good risk-reducing-profit-preserving trade decisions. Please note: All decisions cannot be winners. However, the successful trader makes many good decisions and few poor decisions.

When a position reaches a stage at which we feel that the chances of losing ‘too much’ money are higher than we want them to be, it becomes uncomfortable to own the position. The correct remedy is to control that risk. We can do that by reducing position size (exit part of the position), exiting, or making a risk-reducing trade that adjusts the position to our meet current risk-management guidelines.

To accomplish this necessary objective, we must accept the fact that we are making a difficult decision and we do the best we can. We cannot worry about discovering something we could have done that would have worked out better this time. If there is clear evidence that we made a poor decision under the given circumstances, then we have learned something useful that should help next time. The true skill for a trader to develop is the ability to make that ‘good’ decision with confidence. If you lose money, so be it. We know that we cannot earn a profit on every trade. However, when we stubbornly refuse to needed action, there is no one else to blame.

Back to your specific problem

I know it is an unhappy event to take a loss, especially when the gain was so large at an earlier stage. But that is part of the statistics “game.” “Good” things might happen about as often as expected, over the longer term. That also goes for “bad” or unlucky things. I have nothing that will make you feel better other than following a sound game plan makes it more likely that you will have satisfactory results over the longer term.

You had a plan and a profit objective. If paying 35 cents was good enough to satisfy that profit target, then I believe a reasonable compromise (assuming that you no longer wanted to exit the trade at that price) would have been to cover one-half of the trade, and establish a new target for the remainder. However, if you had no real plan, it is difficult to judge whether you were being greedy. Greediness is a poor choice that could have worked out well for you. In fact, it could have worked most of the time. However, this is the major point of my argument: When we sell premium, there is a maximum possible profit. At some point, the remaining potential becomes too small for the risk. This time, you were trying to earn another few nickels on the trade – and those nickels can add up to real money. Your decision has to be: do I want to hold out for another 15 cents when I am risking something in the neighborhood of $2.50 (that number is based on the fact that you paid $3.05 to exit, losing $2.70 from the earlier point)? Either ‘yes’ or ‘no’ is acceptable. What is not acceptable is not having a plan that answers that question.

The most effective defense (in my opinion) is to exit the trade when you are satisfied with the gains. Knowing when that occurs - well that's another matter.

Your final sentence says a lot: Sure you could have done better on this trade. But, please remember the other trades where you made extra money by NOT paying 35 cents to exit. These small wins add up and may even represent more than enough cash to cover this specific loss. No single method works every time. Unexpected things do happen. One big part of risk management is consistency and not changing your plan every time some trade does not work as planned.

We will have losses. No open position is entirely safe. But you are in control and can make good decisions.

Regards,
Mark D Wolfinger
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