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The Market Guys

Options and Risk Management¹

One of the biggest challenges traders face is keeping their emotions out of trade decisions. Professional traders often rely on colleagues to help them control risk, but most traders are on their own. No one is reminding you to exit trades or reduce risk before the close each day, so you are more likely to hold losing positions overnight.

Managing risk is fairly straightforward for stock and futures traders, who can simply set stop-loss orders and exit trades without too much slippage. If you trade highly liquid stocks, for instance, you can often exit trades within pennies of your stop price.

For options traders, however, controlling risk is more difficult because of wider bid-ask spreads, time decay, and complex, multi-leg positions that take time to unwind. The following example illustrates how to limit a trade's risk to one percent of account value using standard money management techniques, such as position sizing (e.g., determining how many shares of stock to trade by calculating pershare risk). This approach is translated to option positions by using each option's delta to determine how many contracts to trade.

The one-percent rule

The one-percent rule for managing risk limits your loss on a trade to one percent of total account value. This rule is especially helpful when you apply it to an entire portfolio. If, for example, you are holding five positions and are stopped out of all of them, your entire portfolio won't lose more than five percent.

It's not always possible to limit risk to one percent because markets sometimes open much higher or lower than their previous closing price. Such large opening gaps typically appear after surprising (good or bad) news hits the Street; they can hurt a trade before you get a chance to exit.

Despite this caveat, the one-percent rule allows you to set a predetermined exit point for each position. Consider an example of how to use this rule when trading stocks and futures. To calculate the risk amount based on a $100,000 account:

Risk amount = 1 percent of account value = 0.01 *
$100,000 = $1,000

Notice you do not know anything about the actual trade at this point. This is an important point, because many new traders mistakenly believe they should exit after a position moves against them by one percent. However, the one-percent rule is only applied to account equity and is just a first step.

The second step is to identify the risk per share. Figure 1 shows Hansen Natural Corp. (HANS) fell in late October before rising from the $62 support level that began to form earlier that month.

Suppose you bought HANS at $64 on Oct. 25. Because there is support around $62, you might place a sell stop at $61, just below that level. The risk per share would be:

Risk per share = entry price ($64) - stop price
($61) = $3 per share

The final step is determining position size to calculate how many shares to trade by dividing the risk amount by the risk per share:

Position size = risk amount ($1,000)/risk per share
($3) = 333 shares

This means you could trade up to 333 shares of Hansen Natural, assuming you had a $100,000 account and risked #3 per share.

Figure 2 shows HANS rallied toward a resistance level around $68.50 on Oct. 31 and failed to break above it. Price then fell 10.9 percent to $61 and triggered the sell-stop order at 1:50 p.m. ET on Nov. 5. Ideally, you should have exited this trade when Hansen Natural failed to break above resistance - a bearish sign. But even if you held HANS when it tanked in early November, your loss would have been capped at $1,000.

Applying the rule to options

You can use this same risk-management approach with options by using delta to adjust the per-share risk.

Instead of buying HANS at $64 on Oct. 25, you could have bought one June 2008 55 call option. The call cost $16.20, included about $9 of intrinsic value, and expired in eight months.

Table 1 shows the trade's details. To apply the one-percent rule to this trade, multiply the call's 0.70 delta by the $3 risk per share amount. (It is more precise to account for delta's change [gamma] as HANS price falls, but the "static" delta value of 0.70 provides an adequate estimate.) If HANS dropped from $64 to $61, the call's bid should decline from $15.70 to $13.60, because a $3 per-share drop should roughly equal a $2.10 decrease (0.70 delta * $3) in the call's bid. Based on an exit price of $13.60, the call's risk is $2.60, and you could buy up to 385 shares or four calls and still limit your total loss to $1,000.

Alternately, you could have bought a (front- month) November 2007 55 call option for $10.90 (Table 2). This option had a delta of 0.85. To apply the one-percent rule, first calculate the exit price of $7.95 ($10.50 bid - [0.85 delta * $3 risk]). Based on this exit price, the option's risk is $2.95, and you could buy up to 339 shares, or just three calls.

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1 This article ("Article") has been written and provided by The Market Guys, an independent third party that is not affiliated with E*TRADE Canada Securities Corporation ("E*TRADE Canada") or its affiliates. The Article is provided to you for informational purposes only. No information contained in the Article has been endorsed or approved by E*TRADE Canada, and E*TRADE Canada is not responsible for the content thereof or for any third parties (including The Market Guys), or for any third party opinions, products or services. E*TRADE Canada does not provide investment advice or recommendations and you will consult with and rely upon your own advisors. You are fully responsible for your investment decisions and any profits or losses that may result.