Risk management in an option selling strategy

The most important part of any kind of trading plan is proper risk management. This is the area where most traders fail and end up wiping out their accounts. In this post I’ll outline the components of a good risk management strategy and use the option selling strategy I’ve discussed before (here and here) as an example. Actually, risk management applies to any kind of trading whether its selling options on stocks or just buying or selling the stocks themselves. It really is a money management strategy. We’ll just use option selling as one example.

There are three major components of a risk management strategy. First to allocate a maximum loss of your account equity per trade. For example, 1% of equity is a common number for a decent sized account. If your account is $100K then your max loss per trade is $1K. This will prevent any one trade from getting out of hand. Now, this doesn’t mean your position size is limited to 1%. You could enter a position of $20K but then you would need to stop out with a 5% max loss which would be $1K.

The second component is to set a maximum loss per month. There will be times where the trading gods seem to be aligned against you or you’re just not ‘feeling it’. Your not seeing the setups, your distracted, whatever. This rule limits the losing streaks. As an example, you could set a max loss per month of 3%. With the max equity loss per trade in the first component this means you could tolerate 3 consecutive losing trades of 1%. Once you hit the 3% you stop for the month, no more trading. Go back and review your trades to see if you did anything wrong. Or was it just a crappy market and you shouldn’t have traded at all?

The third component is to set a maximum draw down amount for your trading account for the year. Draw down is the maximum peak to trough drop in the dollar amount of your account equity. If you have allocated $100K to trade then a maximum 10% draw down would mean a max loss of $10K, leaving your account at $90K. The purpose of this rule is to live to trade another day. You must preserve capital. With the first two components this means you could continue trading for a little more than 3 months or 10 consecutive losing trades. If you get to this point then you’re done for the year. Either you’re doing something really wrong or the market environment is really bad. For example, a strategy of selling puts for income in the 2008 market downturn would have been hard to make money on. A more aggressive trader could use a 20% max draw down and tolerate a 6 month losing streak or 20 straight losing trades. Any more than 20% is way too much in my opinion.

Let me summarize these three basic components. I think these percentage limits are good for accounts down to about $100K.

1. Max equity per trade – 1%
2. Max loss of equity per month – 3% (3 consecutive losing trades)
3. Max drawn down – 10% of account equity (10 consecutive losing trades, about 3 straight losing months)

As your trading account grows, or as you get older, you can get even more conservative. As I get older I get more risk averse so my parameters are more conservative than the above. I use a max equity per trade of 0.3%, max loss per month of 1.5% and a max draw down of 10%in a given year.

Now, lets see how these money management parameters would work with an option selling trade. Lets say you have a $100K trading account and you sold a cash secured put on a stock with a notional value of $25K that expired in 1 month and collected a premium of 2% or $500. With the money management rules in place your max loss on this trade is $1K. So, if the stock moved low enough during the month where the option premium increased to the point where your loss on the position is $1.5K then you would buy the put back and close the trade for a net loss of $1K (-$1.5K + $500).

Finally, I’ll end this post with some comments from a great trader, Peter Brandt, with a long track record who I’ve learned a lot from. He wrote recently.

There are many reasons why 80% to 90% of novice traders end up losing money. Among the reasons include:

• Being under capitalized
• Taking way too much risk (expressed as a % of capital per trade)
• Attempting to pick tops and bottoms
• Chasing markets
• Becoming obsessed by a scenario (e.g., Silver MUST go up)
• Trading with trading range
• Being compelled to become a day trader

I believe the above reasons, in composite, account for 80% of the failure among pedestrian traders.

There are many technical aspects of trading that need to be learned. There are many things you can do to increase your odds of successful trades but none of this will matter if you don’t have a proper risk/money management strategy in place and learn to stick to it. I hope this post helps you along that path.