Options for Managing Risk

  • Posted by
  • on December 3rd, 2010

“If I sold that stock now, I’d lose my position; and then where would I be?” Old Man Partridge

Fans of Jesse Livermore probably have that line forever etched into their brains…if you don’t recall it, take a look at this post from Tischendorf Letter.  I can’t help but think of Old Man Partridge whenever TraderFlorida drops into StockTwits with one of his classic lines like “this is what strong stocks do…move up strong then rest then move up again.”

Maxims like these we know, but how many of us prove capable of executing them?  Like Michael Jordan telling guys to not accept losing, or a parent telling a heartbroken teenager to move on to the next love, there is a disconnect between the simplicity in the advice and a difficulty in putting it into practice.  I write what I write because I’ve been crushed more than once by an inability to execute that which I now preach…maybe I should include in every post “here’s one way I’ve failed, and steps I took to prevent the same failure again”.

Back to holding winners…what works for me?  Long options, pure and simple.  Experience has made it easier to hold for most of the 2-5 day swing that had set up within a longer term move.  But my natural response at that point is to exit…get stopped out, take profits, whatever.  I sometimes think I should be satisfied with that, but quite often the leaders we later recognize have started with one of those 2-5 day moves.  Once departed, it’s SO hard for me to identify a secondary entry point to reclaim my position in one of those real winners.

So I’ve learned to use options.  Yes, they can be thin, and they have spreads, and they have greeks, and they trade only 9:30-4.  Those are the reasons I kept my usage limited for so long.  How about the positives:

1) Defined risk- can lose premium paid and nothing more

2) Efficient use of capital- can acquire position with 10-20% of the capital required to hold common

3) Positive skew- can grab most of upside or downside tail but risk limited to premium

Trust me, it’s a total pain to build client strategies incorporating options.  But how about the emotional pain of keeping extra capital at risk, or scaling out of so much of a winner that when it makes its REAL move we have only a tiny amount left?  With options, I can continually adjust my strike price as the stock moves in order to keep the risk profile the same as I had originally intended.

I’ll leave deeper discussion for experts like Adam Warner, Bill Luby, Mark Wolfinger, and Jared Woodward, but can share quick examples from this week.  Terrible ideas like being short $COF and $WHR will likely have me stopped out of the puts as they’ve demonstrated too much strength this week…easy decisions to move on, thankfully puts have me losing only so much no matter how much the stocks rise.

What about good ideas like being long $XLY and $TSO?  Bullish moves have accelerated with the market’s rally, and I have no choice but to restore the amount I originally intended to risk.  So I roll out of the $XLY Dec 34 Call and into the Jan 36, and out of the $TSO Dec 14 Call and into the Jan 16.  It costs a little in spreads and fees, but both of those are far less than in years past.

Time?  How about 20 minutes of annoying busywork vs. the hours of admittedly enjoyable time I spend searching for ideas?  Worth it when you think about it…it IS a bull market, you know.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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