Risk Management, or How to Not Lose Your House

by boii0708

TLDR; make smaller trades, trade different stocks for diversification, and make sure your portfolio isn’t 100% dependent on either the market or volatility going in a particular direction.

I’ve been seeing a lot of posts lately from people blowing up their accounts in one way or another, and I would say most if not all of these happened because of a lack of risk management. When you’re trying to build an options portfolio, there are strategies and rules you can implement to minimize the chances of half your portfolio evaporating.

Money Management and Position Sizing

There was a study in 2016 where participants were given $25 and were asked to bet on coin clips for 30 minutes. The coin was weighed so it would land on heads 60% of the time, but the payout was 1:1. Despite the obvious mathematical advantage, 28% of the participants wiped out. out of 61 participants, 18 bet their entire bankroll in one go.

Position sizing is especially important when options trading. Yes, you might have an edge, but variance is always worse than you expect. If you wouldn’t bet your net worth on a coin toss, why would you bet more than you can afford to lose on weeklies that expire worthless 70% of the time? By keeping your individual position sizes small, you reduce the risk of any single trade wiping you out. Check out the Kelly criterion if you want to learn more about “optimal” betting sizes.

Personally, I try to keep the risk of each position under 5% of my portfolio. That doesn’t necessarily mean that I can only spend 5% of my portfolio buying power on one trade, but I might have a stop loss equal to a 5% loss of my overall portfolio.

For example, if you have a $1,000 account, you can spend $200 on RKT weeklies if you want, but if you follow the 5% rule, you should have a stop loss and close the trade when your calls lose $50.

On top of that, I wouldn’t have more than 50% of my account at risk at any given time. This way, I can buy the dip when it happens, or give my (short) positions a bit of extra margin if things go wrong. Options utilize leverage, so you don’t need to use every dollar of buying power available to you.

Asset Diversification

Aside from keeping your account in multiple smaller positions, you want to keep your holdings in different assets. If you have a bunch of small positions but they’re all in meme/tech stocks, you’re probably not having a good month right about now. Spread out your trades across different sectors of stocks. A portfolio with PLTR, RKT, BLNK, NIO, and TSLA is going to be a lot risker than a portfolio with PLTR, GLD, SPY, BA, and TLT. I’m not saying don’t trade the meme stocks, but they shouldn’t be 80% of your portfolio.

Good tickers to trade are liquid, well known, and generally not too correlated with each other. An example watchlist could be AAPL, BA, CRSR, SPY, IWM, QQQ, PLTR, GLD, WMT, and MS. The broad market indexes SPY, IWM, and QQQ are more correlated than most, but you can use them to adjust your portfolio – IWM is more small caps, and QQQ is good for tech exposure.

Directional Diversification

In addition to trading different stocks, you might also want to trade in different directions. Stocks in different sectors might be less correlated, but a broader market downturn could still hurt your portfolio. You might want to have long deltas for some of your positions and short deltas on other stocks.

Maybe you think that the financial sector is going to outperform and tech is on a bit of a downwards trend, maybe you want to be short tech for a while instead of just waiting to buy the dip. I’m personally a net seller of options, so I might sell put spread on MS and call spreads on AAPL. This way, even when the broader market dips I’m okay since at least one of my trades will do really well.

It’s good practice to look at the beta of your portfolio, and see what your PnL looks like compared to moves in a benchmark of your choice. Your broker should be able to calculate how correlated individual stocks are to your benchmark and determine how your portfolio is affected by market conditions. If your broker doesn’t do that, please get a better broker. If you’re playing on Robinhood with a few hundred bucks, fine. But if you’re trading seriously and have a profit goal instead of an entertainment budget, please switch to something like TOS or IBKR.

For me, IBKR’s risk navigator lets me know that by next month, I’ll make $500 on my overall (theta gang) portfolio as long as SPY stays within +/- 5% of where it is today. Of course, I can boost my returns even more through managing my trades; squeezing some more gains out of my winners, and losing the minimum on trades that go wrong.

Volatility Diversification

Ever hear of IV crush? When you buy calls right before earnings, your stock pops up 10% the next day, and you still lose all your money? That’s implied volatility working against you. Similarly, if you’re only long vega and the market + the VIX calms down, it’s suddenly a lot harder for you to make money. Even directionally uncorrelated assets like SPY and TLT have correlated volatility; when the market tanks, everybody rushes into bonds for safety. While SPY falls and TLT increases, both have become more volatile for different reasons. If you’ve only got Iron Condors on these two tickers, you might be in trouble.

Have some positions that benefit from increased volatility and some that are the other way around. If you only have short strangles and credit spreads, maybe try some calendar spreads on stocks with lower volatility. If you only have debit spreads, maybe you might want to sell some Iron Condors on med-high IV rank stocks.

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.

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