The Usual Options Caveats

Before we dig in, I have to strongly reiterate that options trading is not for everyone.  Speculation itself is defined by Webster's massive dictionary as "engagement in business transactions involving considerable risk but offering the chance of large gains, esp. trading in commodities, stocks, etc., in the hope of profit from changes in the market price."  Speculators and non-speculators alike can never forget this definition.  Most folks immediately zero in on the seductive "large gains" portion while ignoring the double-edged-sword nature of speculation.  In order to have the "chance of large gains" a speculator also has to totally and completely accept the "considerable risk" involved.  Just as in any human endeavor, the biggest rewards are only possible for those willing to take the biggest risks.  There is no such thing as speculation without a very real and immediate risk of loss!

The Muddled American Cultural View of Risk

There is no special valor in speculating and no shame in not speculating.  Some of us are hardwired to be tolerant of big risks and some are not.  Our modern American culture sends mixed messages about risk, confusing the issues for many.  For example, Americans tend to greatly over-insure themselves against every conceivable low-probability risk.  Americans also seem to want a Big Brother government to protect and insure them against all of life's countless uncertainties.  All these common traits are signs of very low risk tolerance.  Yet, at the same time, most Americans willingly choose to become big leveraged speculators, making giant macro bets about future market prices at staggering levels running a half-dozen times their annual incomes or more!  A house mortgage, a debt-leveraged speculation often undertaken at 5x to 20x margin, is phenomenally risky.  This magnitude of debt leverage makes options trading look like playschool, yet paradoxically most Americans view options speculation as hyper-risky but macro real-estate speculation as perfectly safe!  These kinds of striking inconsistencies in cultural risk tolerance tend to obscure risk issues.

Regardless of whether you choose to be a speculator or not, in any conceivable market, understanding and managing risks is a very valuable skill to acquire.  Since my consulting clients were inquiring about risk management from the perspective of index-options trading, this letter assumes that focus.  But these same principles can be applied in all other kinds of speculations too, so even if you are not an index-options trader this is important knowledge to seek.

Strategic Passive Portfolio Risk Management

Interestingly the ultimate risk-management strategies for speculators are activated well before a single dollar is deployed.  I use these techniques extensively in my own personal portfolio and have discussed them a few times in the past.  Before a speculator even speculates, he or she must make some crucial decisions on portfolio allocation.  Out of your entire capital portfolio, what percentage of your assets are you willing to risk on speculations?  This number varies considerably.  Some people crave risk and are blessed to sleep like babies even with big bets on the line.  Other folks are not willing to sacrifice even a sliver of their hard-earned capital to the capricious vagaries of market fate.  Now once again it is important to realize that there is no honor and no shame in leaning towards a more aggressive or more conservative stance as a speculator!  Risk tolerance, like most of the building blocks of our individual personalities, is one of the wonderful elements that renders each of us unique.

Both aggressive and conservative speculators can certainly achieve dazzling success.  George Soros and Warren Buffett both became billionaires by trading, but one was an aggressive gunslinger and the other a far-more conservative long-term value player.  In your own case, carefully consider your entire portfolio and pick a number.  Perhaps you are willing to risk a maximum of 3% of your assets in risky speculations.  Maybe you are willing to risk 30%.  Either way, you absolutely have to define up front before you engage in actual speculations exactly what your maximum acceptable exposure will be.  After carefully deciding your overall portfolio division between relatively low-risk investments and high-risk speculations, maintain iron discipline to keep these pools of capital separate.  If 10% is your magic risk-tolerance number, make sure, no matter what, that at no time do you ever bet more than 10% of your entire fortune on all your risky speculations put together.  While this sounds quite basic, I can't tell you how many folks I have seen get in trouble because they over-speculated!  Just like you would set aside a fixed amount of cash to gamble before you visited Vegas, you have to know in advance how much total portfolio speculation risk you are willing to bear.  This is the first step of passive portfolio risk management.

The Second Passive Risk Step

After deciding on your maximum strategic portfolio allocation to speculations, you can engage in the crucial second step of passive portfolio risk management prior to launching any speculative trade.  This key discipline applies regardless of what type of speculation you are considering from index options to untested junior gold stocks to penny tech stocks.  Before pulling the trigger on any speculation, search your heart and decide exactly how much capital you are willing to completely lose if your bet turns sour.

Yes you read that right!  Speculation is risky, so prior to even deploying capital make darned sure you can live happily ever after if a trade doesn't play out the way you hoped.  If you are considering betting $5000 on an index-options play, for example, you have to know in advance that you can kiss that capital goodbye in the worst-case scenario and go on with your life without any emotional baggage.  This crucial discipline ensures two things.  First, it makes you carefully consider the size of all your trades.  All speculators know how easy it is to get all caught up in the moment when a particularly promising trade comes along!  Rather than being blinded by visions of dazzling profits seductively dancing through your mind, instead think of the worst-case-scenario 100% loss to ensure that it is acceptable to you if that particular trade doesn't pan out.  Limit all of your trades to a size where a total loss won't seriously injure you, either financially or psychologically.

Second, thinking in terms of the worst-case scenario in all trades prior to deployment helps you keep your overall speculative portfolio balanced.  In addition to carving up your entire portfolio into totally separate portions dedicated to investment and speculation as we discussed earlier, you also need to make capital-allocation decisions within the speculative portions.  This can be quite challenging, since there are always competing speculation opportunities today and tomorrow that you must decide between.  Entering each new trade aware of a potential 100% loss helps keep speculators from over-allocating to a single trade.  For example, if your maximum exposure to speculation is 10% of all your financial assets, perhaps your maximum individual-trade exposure will be 10% of speculations, which is 1% of your entire capital base.  Understanding that each potential risky speculation could very well prove to be a total loss helps ensure that you don't over-allocate into any single trade and risk wiping out your entire pool of speculative capital on one tragic massive bet.

All-Or-Nothing Speculating

Personally, this is how I have long-managed all my own speculation risk.  Rather than actively managing trades already in progress, I am meticulous and ruthless in ensuring that I never risk too much on any single trade.  All of this passive portfolio risk management is done before a dollar is even thrown at the markets.  I seek out an opportunity, I decide what amount of capital I am willing to completely lose if the markets conspire against me, and only then will I pull the trigger and make the bet.  If I am blessed with a win on a particular trade I praise God and rejoice, but if I suffer a loss I am able to shrug and move on because I never risked enough capital in any one trade to really damage my portfolio in a worst-case-scenario total loss.

Now I still won't hesitate to close in-progress trades, at either losses or wins, if I perceive that the underlying conditions that led me to originally make any given trade are no longer in force.  For example, on QQQ index puts, which are ultimately a valuation and sentiment play, I would sell them instantly if the earnings of the mega-tech companies miraculously tripled, eliminating the valuation play.  I would also dump them immediately if widespread fear hijacked popular market sentiment.  But as long as the original market conditions that led to any risky speculation still remain, I'm quite content to leave the speculations alive.

I really like this all-or-nothing approach because I have found that it dramatically reduces overall speculation stress for me.  I find and study a potential speculation opportunity, decide how much I am willing to risk, make the bet, and then I live with the consequences win, lose, or draw.  At all times I know exactly how much of my scarce capital I am risking.  I also always know that I can fully absorb all speculation losses without financially or psychologically damaging my ability and means stay in the great game.