Kaeppel's Corner: When the Risk Comes Down
June 17, 2009
One of the greatest keys to making money is not to lose money. Now I will grant you that this sounds fairly obvious, yet the more you think about this statement and the more you analyze the implications, the more profound it becomes. Because generally speaking, losses hurt more than profits help. This is true on several fronts.
First off, if you lose 20%, you then need to make 25% to get back to breakeven. If you lose 33%, you need to make 50%. And if you lose 50%, you need to double your money in order to get back to breakeven. Not a happy situation (this is the apparent negative offset to the positive effects of the magic of compounding). Likewise, most traders are far more likely to beat themselves up after a losing trade than they are to pat themselves on the back after a winning trade. And the psychological effects of a trade that experiences a larger than expected loss - particularly if due to a mistake on the part of the trader - can linger for a very long time. A trader who got out too soon the last time may hold on too long next time. And a trader who held on too long last time may be very itchy to take a small profit the next time around - thereby setting himself or herself up to miss a big winner.
The bottom line is that there are a lot of ways to go wrong in the trading game. Hence the reason that risk management is such a supremely important issue. Probably the best old adage in this realm states "if you take care of the losses, the winners will take care of themselves." This is simply another way to say "cut your losses short and let your winners ride."
Understanding the Meaning of Words
Sometimes it is critically important to understand what is being said. Other times not so much. Before I explain this, let me first explain how fortunate I am. When I was a kid there could not have been a wider chasm between the type of music my father liked and the kind of music I liked. My father was into Big Band and I was more focused on songs involving guitar solos, typically the louder the better. And neither of us had the slightest appreciation for the other's preference. "This is music," my father would state assuredly as the clarinets or whatever would begin to blow. "Yeah, boring music, Dad," I would intone, although usually under my breath. And of course I didn't really help my own cause much. My Dad would claim that rock musicians had "no talent" and I would helpfully explain how hard it must be for them to remember all the chords while they were stoned out of their gourds. And when I went to my room and turned it up just a little too loud my Dad would come in and stand there glaring at me, slightly resembling a man standing on the deck of a ship in a storm at sea.
Fortunately, my son and I don't have this problem. Because Jimmy is an old school rocker. In fact, I think he likes rock and roll even more than I do. Nowadays when we get in the car, even before I have a chance to launch into explaining the meaning of life, or how he can learn from my experience and wisdom, or how could he strike out with the bases loaded, he already has the radio locked onto the Classic Rock station. He has even formed a band and given it a name ("Rug Burn," which I like). Now if only he and his other eleven-year-old friends could learn to play an instrument beyond Guitar Hero, well, the sky is the limit.
No, the only real problem we have is that Jimmy wants to understand the meaning of the words. Now I have explained to him time and again that trying to understand the words to a rock song, let alone to understand their actually supposed meaning, is one of the greatest wastes of time in which any person can ever engage. Still he persists. So one day we heard "When the Whip Comes Down" by the Rolling Stones, and since everything except those five words is completely unintelligible, I foolishly agreed to Google the lyrics when we got home. Up came the first stanza:
"Yeah, mama and papa told me
I was crazy to stay
I was gay in New York
A fag in L.A.
So I saved my money
And I took a plane
Wherever I go they treat me the same
When the whip comes down"
(repeat four times)
Okay. Isn't rock n' roll great, son? And the finish was nice too:
"Yeah, baby, when the whip comes down
When the whip comes down
(I'll be running this town, I'll tell you)
When the s*** hits the fan
I'll be sittin' on the can"
When it all hits the fan, I'll be sitting on the can. Is that a life lesson for the kiddies or what? To make a long story short, we don't Google rock n' roll lyrics in our house anymore.
So what does all of this have to do with trading? Only that for traders, trading is only one part of life, and as Father's Day approaches it is a good time to reflect a bit, both forward and back. And also - and more to the point - to note that things are often less stressful for investors and traders "when the risk comes down."
When the Risk Comes Down
So let's look at a handful of strategies that allow a trader to enter a position with the comforting knowledge that (as long as they do it right) the downside risk can be limited.
The Collar
For most of my life, "the collar" was a baseball term, as in going 0 for 4 was referred to as "going for the collar." I assume that that is some sort of "choke" reference. But in option trading, the "collar" is a good thing, or at least it can be. Essentially this strategy chokes the risk out of many situations. A collar is entered by selling one call option and buying one put option for every 100 shares of stock held. If a collar is entered properly, then as long as the option positions are held, downside can be held to a bare minimum.
The collar can be used as an ongoing strategy with the collar being "rolled up" or "rolled down" to readjust to a favorable reward-to-risk ratio. Any time you want to limit your risk on a position to a bare minimum without selling the underlying security, the collar strategy is one of the first to consider. Figures 1 and 2 display a collar trade using Amgen (AMGN) stock and options.
Figure 1 - AMGN Collar
Figure 2 - Risk Curve for AMGN Collar (reward-to-risk > 4.0 and max. risk = $91)
As you can see in Figures 1 and 2, the worst thing that can happen to the holder of this position is that he or she will lose $91 over the course of the next 35 days. On the flipside, upside potential is limited to $409. Yet there are several things to remember. First, the reward-to-risk ratio is over 4-to-1. Also, if AMGN moves higher, it may be possible to "roll up" the collar and achieve a similar reward-to-risk ratio from a higher level.
The Married Put
One negative to the collar strategy in the eyes of some traders is the limit on upside potential. For those traders a different possibility is a strategy known as the "married put." This simply involves buying a put option to hedge a long position of 100 shares of stock or one futures contract. One advantage of a married put is that, like the collar, you put an absolute limit on your downside risk. The key advantage of this strategy relative to the collar is that profit potential remains unlimited.
Figures 3 and 4 display a married put trade once again using AMGN stock and options.
Figure 3 - AMGN Married Put
Figure 4 - Risk curves for AMGN Married Put
As you can see in Figures 3 and 4 the key pieces of information are:
- The trade has unlimited profit potential.
- The maximum risk is limited to $468.
- The breakeven point for the trade is 54.68.
The bottom line here is that you pay a price for everything in life. If you want to limit your risk on a trade you can buy a married put. The price you pay is that your breakeven price for the trade rises by whatever amount you pay to buy the option. Still, if you are concerned about a break to the downside but are not ready to sell your shares, this strategy is simple and highly effective at putting a "floor" under your stock.
Summary
The fear of risk, i.e., the fear of losing money - is what keeps traders and investors up at night. And this is not necessarily unfounded based on the monetary and psychological reasons I explained at the outset. As a result it is helpful to have some methods for limiting downside risk at your disposal. Both the collar and the married put allow any investor or trader to quickly and easily put a very tight limit on the amount of risk they are exposed to on a given trade.
Most all investors and/or traders would do well to learn and understand how to utilize these strategies to make "the risk come down," before "the whip comes down."
Jay Kaeppel
Staff Writer and Author of "Seasonal Stock Market Trends"
Optionetics.com ~ Your Options Education Site
Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.
NOTES:
I will be teaching a session on Seasonal-based trading at this year's Optionetics OASIS, June 18-21. I look forward to seeing many of you there. For more information about this incredible event, please click here.
To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.
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