Risk Management
Presented by Lawrence G. McMillan “The Option Strategist” Continuing Webinar Series
www.optionstrategist.com 1-800-724-1817 [email protected] McMillan Analysis Corp. A Derivatives Firm
Recommendations (newsletters) Money Management Option Education including Mentoring www.optionstrategist.com/mentoring
www.optionstrategist.com 1-800-724-1817 [email protected] Special offers on most of our newsletters, software, and educational products
Visit: www.optionstrategist.com/webinar
www.optionstrategist.com 1-800-724-1817 [email protected] Today’s Topics Position Sizing The Concept Of Expected Return Stops and Partial Profits Using Greeks to Manage Risk Portfolio Protection
www.optionstrategist.com 1-800-724-1817 [email protected] Determining Trade Size
• Fixed Percent of Assets • The Kelly System • Optimal f • Probability of Ruin
www.optionstrategist.com 1-800-724-1817 [email protected] What NOT To Do…
• Double up to catch up • Martingale: –1 –2 –4 –8 –16 +32 = +1
www.optionstrategist.com 1-800-724-1817 [email protected] A Better Approach…
• Increase size as you profit • Fibonacci-style: 10, 15, 25, 40, 65, 105, 170, 275, … 7 wins, 1 loss: +$155 vs +$60 Return to initial size ($10) when you lose
www.optionstrategist.com 1-800-724-1817 [email protected] How Many Options Should I Buy? Fixed Percentage Risk Management Risk a fixed percent of your account on each trade (3%, e.g.) Automatically increases when you win and decreases when you lose Example: Account size = $100,000 You plan to risk 5 points on a stock trade Therefore, buy 600 shares of stock (3% risk)
www.optionstrategist.com 1-800-724-1817 [email protected] How Many Options Should I Buy? You could figure your risk = premium, but that’s unrealistic.
Option costs 10 points ($1000) So buy 3, if your account size is $100,000 (3% risk)
www.optionstrategist.com 1-800-724-1817 [email protected] How Many Options Should I Buy? Using the model to estimate risk. Oct 100 call costs 10 today ($1000). What would it be worth if XYZ fell to 95 in a week?
Black-Scholes model says: In 1 week, if XYZ = 95, Oct 100 call = 7 Therefore, risk = 3 points ($300) so you can buy 10 calls, not 3!
www.optionstrategist.com 1-800-724-1817 [email protected] Another Approach: The Kelly Criterion J. L. Kelly, Bell Labs, 1954 Original Formula: Amount to bet = (W + L) * p – L Where W = amount you could win L = amount you could lose p = probability of winning
If result is negative, don’t bet www.optionstrategist.com 1-800-724-1817 [email protected] Applying Kelly: Sports Betting
In sports betting L = 1.1 * W (you lay $110 to win $100) Amount to bet = (W + 1.1W) * p – 1.1W = W *( 2.1p – 1.1) Will be negative if p <= .52
Assume W = 1 (your risk bankroll) Amount to bet = 2.1p – 1.1
www.optionstrategist.com 1-800-724-1817 [email protected] Kelly: Sports Example
Amount to bet = 2.1p – 1.1 Example, assume p = 60% (i.e., you can predict sports winners with 60% accuracy*) Then amount to bet = 2.1 * .60 – 1.1 = .16 which means risk 16% of your bankroll on the next bet. *: if you can do that, you don’t need this seminar
www.optionstrategist.com 1-800-724-1817 [email protected] Kelly: More Complex Situations
Applying (W + L) * p – L Where p = probability of a winning trade
PDR System: avg win $2359; avg loss $1952 And p = 56.7% So L = .83W Amount to bet = (1.83p – 0.83) Amount to risk = 21%
www.optionstrategist.com 1-800-724-1817 [email protected] The Probability Of Ruin Define “ruin:” down 80%? If you risk 50% of your capital, and lose it all on each trade, then: One loss: 50% left Two losses: 25% left Three losses: 12.5% left = ruined!
www.optionstrategist.com 1-800-724-1817 [email protected] The Probability Of Ruin Define “ruin:” down 80%? How many losses in a row would ruin you? (1 – r)n = 0.2, where r = % of assets you risk on each trade If r = 3%, n = 52 If r = 50%, n = 2.3
www.optionstrategist.com 1-800-724-1817 [email protected] More on the Probability of Ruin
Kelly is designed to optimize your results, not protect your capital! Professional blackjack players rejected Kelly because the probability of their bankroll shrinking to any percentage was that percentage itself. 50% chance of losing 50% 20% chance of losing 80% 10% chance of losing 90% Was too much risk for them
www.optionstrategist.com 1-800-724-1817 [email protected] Kelly for Traders
• Our investment is not equal to our risk • Our win amount is not fixed, either • We don’t make sequential investments • Not all of our trades have equal probabilities of profit (unless we only trade one system) Reference: Google papers by Edward Thorp
www.optionstrategist.com 1-800-724-1817 [email protected] Optimal f
f = Kelly formula According to Ralph Vince, in a complex trading system, the f that provides the maximum return on our money can only be determined by iteration. We cannot average our wins and losses from trading and obtain the true optimal f using the Kelly formula. Your Bet unit = (System’s Largest loss) / f The full concept of understanding Optimal f requires reading the book.
www.optionstrategist.com 1-800-724-1817 [email protected] The Concept of Expected Return
A logical way to analyze, compare, enter and exit strategies
www.optionstrategist.com 1-800-724-1817 [email protected] What is Expected Return?
The return one could expect to make on a position over a large number of trials. Assumes the distribution of possible stock prices can be defined; also assumes implied volatilities of an unexpired option can be estimated as well. Highly dependent on volatility estimate.
www.optionstrategist.com 1-800-724-1817 [email protected] Expected Return Example A Call Bull Spread XYZ: 52 Oct 50 call: 7 Oct 60 call: 4
Assume the stock must be at one of the following prices: Stock Price Probability < 50 45% 52 8% 54 7% 56 6% 58 4% >60 30% Total: 100%
www.optionstrategist.com 1-800-724-1817 [email protected] Calculating The Expected Profit
Now, add in the profit picture of the strategy:
Stock Price Prob Profit Expected Profit < 50 45% -$300 -$135 52 8% -$100 -$ 8 54 7% +$100 +$ 7 56 6% +$300 +$ 18 58 4% +$500 +$ 20 >60 30% +$700 +$210 Total: 100% +$112 www.optionstrategist.com 1-800-724-1817 [email protected] How Will This Spread Do?
• Expected Return = $112 / $300 = 37.3% • Annualized Exp Return = 37.3% x 4 = 112% • But the only point you actually would make $112 is if stock is at 54.12 at expiration. • Chance of that is < 0.005 • In any one case, you could make as much as $700 or lose as much as $300
www.optionstrategist.com 1-800-724-1817 [email protected] What is Expected Return NOT?
• It is not a black box, “magic” formula • It is not a guarantee of profits • It is not a shortcut to the diligence needed to trade options profitably
www.optionstrategist.com 1-800-724-1817 [email protected] What Does It Mean? • On average, if you invest in positions with high expected return, you should approach that return eventually • The “Casino Analogy” • Erroneous Assumptions - Distribution not lognormal - Bad volatility estimate - Event Risk www.optionstrategist.com 1-800-724-1817 [email protected] Trading Decisions Based on Expected Return In the bull spread example, Suppose XYZ moves from 52 to 55 quickly And you have a profit of $120. That’s your expected profit. Should you take it? If you do, your annualized return increases!
www.optionstrategist.com 1-800-724-1817 [email protected] Expected Return on The Strategy Zone and Option Work Bench Our statistics on The Strategy Zone include expected return for • Calendar spreads • Covered Call Writes • Naked Put Sales
www.optionstrategist.com 1-800-724-1817 [email protected] Position Sizing Using Expected Return • Kelly is useful because it optimizes results while increasing our trading size when winning and reducing it when losing • It is a rational way of investing in a consistent manner, placing the most money on the most likely profitable trades • We have expected return as a guide • We can also often determine the probability of winning or losing on a trade • In complex situations, Kelly effectively reduces to:
Amount of account to risk = pwin –ploss
www.optionstrategist.com 1-800-724-1817 [email protected] Applying Kelly
In some cases, we can compute pwin and ploss but that might not relate well to expected return (naked writing, for example) Better to use expected return, e
pwin = (1 + e) / (2 + e)
Ploss = 1- pwin
www.optionstrategist.com 1-800-724-1817 [email protected] EXAMPLE: CEPH Calendar $75,000 account CEPH: 44.60 Buy Aug 45 call Sell May 45 call for 1.20 DB e = 17.2% (not annualized) Kelly Method: pwin = (1+e)/(2+e) = 54% pwin -ploss = 8% So, risk 8%, or $6,000 => 50 spreads
www.optionstrategist.com 1-800-724-1817 [email protected] Portfolio Considerations
Can’t just use the Kelly or Optimal f number for each position: What if Kelly says “invest 12%,” but you have more than 8 positions you want to establish? Two approaches: 1) Use Kelly on remaining equity in account, or 2) Rebalance all positions (daily)
www.optionstrategist.com 1-800-724-1817 [email protected] Recommended Reading Fortune’s Formula “The Untold Story of the Scientific Betting System that Beat The Casinos and Wall Street” By William Poundstone ------Against The Gods “The Remarkable Story of Risk” By Peter L. Bernstein ------The Handbook of Portfolio Mathematics: Formulas for Optimal Allocation & Leverage by Ralph Vince www.optionstrategist.com 1-800-724-1817 [email protected] Risk Management Once the Trade Has Been Made
Stops Partial Profits Rolling Portfolio Greeks
www.optionstrategist.com 1-800-724-1817 [email protected] Speculative Positions Why hedge? 1) Lock in some gains 2) Reduce risk Any time you adjust or hedge a speculative position, you harm your potential profits. Most harmful: partial profits Modestly harmful: rolling As a result, hedging should not be overdone. I don’t like: selling out-of-moneys against long options, hedging calls with puts and vice versa, or other methods of converting long option to another strategy. www.optionstrategist.com 1-800-724-1817 [email protected] Trailing Stops Type of Stops 20-day SMA 10% EMA Chandelier Parabolic
Closing stops recommended
Should be applied to all unhedged trades
www.optionstrategist.com 1-800-724-1817 [email protected] Profit-taking Methods
1) Partial Profit: Sell a portion (quarter or a third) of your position
Or 2) Roll the position: Sell the options you own (when they are fairly deep in-the-money) And buy a strike that is near-the-money
www.optionstrategist.com 1-800-724-1817 [email protected] Profit-Taking: Allows you to book some gains
“I feel I should be doing something” ATK: 17 points as shown 43 points if no partial profits had been taken
www.optionstrategist.com 1-800-724-1817 [email protected] Partial Profits:
Completely eliminates any further gains from the portion that you sold Everyone worries about a gain turning into a loss Works best if stock (or market) is not trending A huge mistake in a trending situation
www.optionstrategist.com 1-800-724-1817 [email protected] Rolling (Up)
Is moderately harmful. WHY? Your position: Long 10 XYZ Jan 50 calls with XYZ = 60 Roll: Buy 10 XYZ Jan 60 calls Sell 10 XYZ Jan 50 calls This is a bear spread, but you are bullish! But at least you retain your upside quantity
www.optionstrategist.com 1-800-724-1817 [email protected] Speculative Summary
• In a trending market, the best gains come from merely holding until your trailing stop is elected. • Hedging/Adjusting in trending markets is harmful • It behooves you to know if the underlying is prone to trending or not. Many commodities and commodity-related stocks trend. • Stocks that depend on fundamentals for propulsion generally are not trending stocks.
www.optionstrategist.com 1-800-724-1817 [email protected] Adjusting Hedged Positions
You should always have a stop whether you are Speculator Naked Option Seller
Maybe even in a limited risk spread
So it is not mandatory to adjust; you could just sit back and let the stops take care of things
www.optionstrategist.com 1-800-724-1817 [email protected] Hedged Strategies
Whether or not to adjust a hedged position, really depends on the strategy and your attitude. For example: Long Straddle Long XYZ July 50 straddle @ $5 Later, XYZ = 55. “Scalper” would sell some stock, looking to buy it back on a pullback. “Trender” would sell the puts, and use a trailing stop on the long calls.
www.optionstrategist.com 1-800-724-1817 [email protected] Simple Adjustment to Hedged Strategies
Adjust stop as time passes to protect unrealized profits: Assume you Sold XYZ Straddle for 12 Now XYZ is near strike and straddle is selling for 6 Stop yourself out if either side goes 6 points in-the-money Similar to trailing stop.
www.optionstrategist.com 1-800-724-1817 [email protected] Simple Adjustment to Hedged Strategies
Or if relationship of profit to stock price is difficult to discern, then adjust your stop in dollars Assume you have July-April 60 calendar spread It is marking up $200 with XYZ near 60, But there is more to be made if XYZ stays near 60. Stop yourself out if your profit drops to $150, say. Similar to trailing stop.
www.optionstrategist.com 1-800-724-1817 [email protected] Position Greeks Calculate the Deltas (Gammas, Thetas, etc.) for all options in a position and add them together. XYZ: 45 Price Delta Gamma Long 5 XYZ July 50c 0.95 +26 4.9 Long 5 XYZ July 50p 5.90 -74 4.9 Short 3 XYZ July 40p 0.72 -19 4.1 Delta: (+5x+26) + (+5x-74) + (-3x-19) = -183 (ESP) Gamma: 5x4.9 +5x4.9 – 3x4.1 = +36.7
Long gamma means you want stock to accelerate; Short delta means you have a downside bias; Hedge: buy ~200 common => now neutral www.optionstrategist.com 1-800-724-1817 [email protected] To Scalp or Not? Whether or not to adjust a hedged position, really depends on the strategy. If you are a “gamma scalper” or “delta neutral trader,” then you would adjust when others might not. In a long gamma position, all adjustments are for the purpose of taking profits; In a short gamma position, all adjustments are for the purpose of preventing losses
www.optionstrategist.com 1-800-724-1817 [email protected] Gamma Determines Attitude
Position Gamma: Long Short Adjustment Whipsaws Good Bad Straight-line/gap Move Good Bad Dull market Bad Good Stop needed No Yes
www.optionstrategist.com 1-800-724-1817 [email protected] Neutralizing Several Greeks
You can always neutralize 2 or 3 of the Greeks, moving exposure to the area you desire. Example: you want to establish a call ratio spread, but you would like to neutralize your market risk and leave only the volatility risk.
www.optionstrategist.com 1-800-724-1817 [email protected] 2 Equations in 2 Unknowns
Position Delta Gamma Theta Vega IV XYZ Jul 50c 45 4.7 -1.9 9.6 35% XYZ Jul 55c 29 3.5 -1.9 8.4 40% To Neutralize Gamma (delta comes later) , while making $100 per point drop in Vega: 4.7x + 3.5y = 0 9.6x + 8.4y = -100 Rounding, x = 60; y = -80 (y / x = 1.33) Delta = 60x45 – 80x29 = 380; so short ~400 shares Theta = +38 (you make $38 per day in time decay) www.optionstrategist.com 1-800-724-1817 [email protected] Staying Neutral
Later, XYZ = 52 Position Delta Gamma Theta Vega IV L 60 XYZ Jul 50c 64 4.9 -2.4 8.1 35% S 80 XYZ Jul 55c 41 4.5 -2.8 8.4 40% S 400 XYZ Position Greeks: 160 -66 80 -186
To Neutralize Gamma and Delta: Buy 15 July 55c: increases Gamma by 15 x 4.5 = 67.5 Increases Delta by 41x15 = 615, so short ~800 more XYZ Leaves Theta +38; Vega –60 (to get back to –100, mult by 1.67)
www.optionstrategist.com 1-800-724-1817 [email protected] Portfolio Greeks
Can’t just add all position greeks together Because different stocks have different volatilities For example, Long 200 deltas in RIMM + Long 400 deltas in VZ Does not make long 600 deltas Rather you must reduce all deltas to a common factor (EFP), such as SPX or QQQ. www.optionstrategist.com 1-800-724-1817 [email protected] Equivalent “Market” Position
Assume “market volatility” = 15% ($SPX, say) ESP Price Volatility Adj.Factor Adj. Dlrs L 800 RIMM 35.5 45% 3.0 $85,200 L 2000 VZ 35.5 15% 1.0 $71,000 $156,200 So this portfolio is long $156,200 as “market equivalent” So, if SPY = 128, then to fully hedge the risk (delta) of this portfolio, you would sell $156,200 / 128 = 1220 SPY
www.optionstrategist.com 1-800-724-1817 [email protected] What Is Portfolio Protection?
“The use of listed derivatives to reduce or eliminate the risk of a general market correction” Most investors view protection as insurance or disaster protection, rather than a complete hedge of their entire portfolio.
www.optionstrategist.com 1-800-724-1817 [email protected] Protecting A Stock Portfolio
Buy $SPX Puts (Traditional) Or Buy $VIX calls (Modern)
www.optionstrategist.com 1-800-724-1817 [email protected] “Macro” Protection • Using broad-based index ($SPX or $VIX) options • Most efficient in terms of cost and effort • Problem: Tracking error “Micro” Protection • Hedge each individual stock with its options • No tracking error • Can be extremely time-consuming
www.optionstrategist.com 1-800-724-1817 [email protected] “Macro” Protection
• Using broad-based index options • $SPX or $VIX • Or other index that represents your stock portfolio • Most efficient in terms of cost and effort • Problem: Tracking error
www.optionstrategist.com 1-800-724-1817 [email protected] “Macro” Strategies
Buy Broad-Based Index Puts Buy Index Put Spreads Sell Index Calls Use Index Collars Sell Index Futures Volatility Products
www.optionstrategist.com 1-800-724-1817 [email protected] Buy Broad-Based Index Puts
• Most Popular Approach; not necessarily the best approach • Typically buy 5% to 15% Out of Money (OOM) • The OOM portion is the “deductible” • With care, can keep cost down to 2% - 3% of NAV • Disadvantage: protection not dynamic if market rallies • Advantages: fixed cost; upside profits unencumbered
www.optionstrategist.com 1-800-724-1817 [email protected] Buy $SPX Puts For Protection
www.optionstrategist.com 1-800-724-1817 [email protected] Buy Index Put Spreads
• Buy bear spreads as a hedge • Drawback: cap on protection • Advantage: lowers cost of protection • In effect, your insurance benefits only engage between the strikes of your spread – a poor approach if you actually need protection
www.optionstrategist.com 1-800-724-1817 [email protected] Sell Index Calls
Drawbacks: doesn’t provide disaster insurance; and may limit upside profits
Advantage: sale of a wasting asset
www.optionstrategist.com 1-800-724-1817 [email protected] Index Collars • Buy OOM puts and sell OOM calls • Calls defray cost of the puts (sometimes completely) • Limits both risk and reward • Distance between strikes is hurt by high dividend and/or low volatility • Best when using LEAPS options (can spread strikes out quite far with LEAPS): June 2007: $SPX: 1517 Feb 2011: $SPX 1340 Dec (’09) 1450 put: 107.6 Dec(’13) 1200p: 120 Dec (’09) 1700 call: 118.8 Dec(’13) 1400c: 125
Nowhere nearly as attractive (vol, div, rates) www.optionstrategist.com 1-800-724-1817 [email protected] Volatility Products
• $VIX • Futures on $VIX • Options on $VIX
www.optionstrategist.com 1-800-724-1817 [email protected] History of $VXO
www.optionstrategist.com 1-800-724-1817 [email protected] Hedging With Volatility Products
Since $VIX moves opposite to $SPX, Buy VIX futures Or Buy VIX calls • Advantages: stock upside unencumbered; cost limited to “time value premium.” • Disadvantages: $VIX derivatives may not track well with $VIX itself.
www.optionstrategist.com 1-800-724-1817 [email protected] $VIX Calls are a better hedge than $SPX puts Better than buying $SPX puts: protection is dynamic If you buy $SPX puts and market rises, your protection is virtually worthless If you buy $VIX calls and market rises, your protection is still viable
www.optionstrategist.com 1-800-724-1817 [email protected] $VIX Hedging Is “Cheap”
According to a well-known study, a portfolio consisting of 90% $SPX and 10% $VIX outperforms $SPX in both up and down markets. Later studies suggest 20% for hedging. So you only need to hedge 10%-20% of your portfolio’s EFP, assuming it performs “in line” with the broad market. Buy out of the money $VIX calls, one or two months out, and keep rolling them. Strike ~= futures price + 7
www.optionstrategist.com 1-800-724-1817 [email protected] How Many $VIX Calls To Buy? • Hedge 20% of your NAV • Assume EFP = $100,000 on 9/16/2008 • VIX Oct 30 call = 4 • You buy $20,000/(30x100) = 7 calls • Stock market down 26% ($SPX 1210 to ~900) • NAV: -$26,000 loss • Oct $VIX Futures: +125%; $VIX +131%; Oct 30 call = 27 • 7 calls x $2300 profit = +$ 16,100 gain • You lose -$9,300 = your “deductible” (9.3%)
www.optionstrategist.com 1-800-724-1817 [email protected] Buy $VIX Calls For Protection
www.optionstrategist.com 1-800-724-1817 [email protected] $VIX Option Protective “Collar”
Buy VIX calls for protection And Sell VIX puts to help fund the calls
Problem: Put premiums small
www.optionstrategist.com 1-800-724-1817 [email protected] Summary
Risk Management is Important: Position Sizing Use Trailing Stops For Speculative Positions For simple hedged positions, use dollar stops For complex positions, hedge with Greeks For portfolios, hedge with $VIX
www.optionstrategist.com 1-800-724-1817 [email protected] Special offers on most of our newsletters, software, and educational products
Visit: www.optionstrategist.com/webinar
www.optionstrategist.com 1-800-724-1817 [email protected] CD Seminar Series
Regularly $499
Show Special $199
www.optionstrategist.com 1-800-724-1817 [email protected] Mentoring
McMillan Analysis Corp. Offers One-on-one Mentoring Structured to your skill level Conducted on the internet or in person Call 973-362-4558 or visit: www.optionstrategist.com/mentoring
www.optionstrategist.com 1-800-724-1817 [email protected] Thank you for attending! Contact information: Phone: 800-724-1817 email: [email protected] Fax: 973-328-1303 web site: www.optionstrategist.com/webinar
www.optionstrategist.com 1-800-724-1817 [email protected]