Managing risk is crucial to a successful trading plan.
Because of this, I am always testing for better ways to manage risk with my strangle strategy. Selling longer termed strangles has proven to be a solid, winning strategy for me, yet one can always improve their ability to reduce the volatility in their portfolio and keep their profits on a smooth upward trend.
Of course, position size is always number one.
The most recent example of this is the OptionSellers.com tragedy, where a hedge fund was blown to smithereens by a natural gas spike. Most mainstream financial writers are using this event to proclaim that naked option selling is too dangerous. However, experienced option sellers know that the fund manager was trading over 20 times the amount of contracts that he should have been. And natural gas futures is a HUGE product (see my post When is a trade too big for my account?).
The importance of position size is why the core of my portfolio is built on ETFs with a market price of $50-250, and I collect a small credit compared to my account size.
Another major factor in risk management is knowing ahead of time when to get out of a trade.
If you have read my previous trading plan posts, you know I was doing a lot of testing based on letting losing positions get to a loss of 3x the credit received before pulling the plug. I was also looking at going inverted and continuing to roll if the strike price of my naked options were actually breached. After much study, I have reached a conclusion.
First of all, I am going back to closing positions that reach a 2x loss.
Yes, a good portion of the trades that go past that limit do eventually become profitable. And yes, many backtests that focus on a single underlying, with one trade on at a time, do show that the 3x loss management is statistically better.
However, from an overall portfolio viewpoint and psychological perspective, I just don’t want those stinker trades hanging around. While they may have a good chance of becoming profitable, they are also more dangerous than my other trades. They are sitting in a spot where the delta of one leg could cause a significantly bigger loss.
One can also look at it this way: If I opened up my portfolio and had no trades on, would I put this losing trade on exactly the way it is? No, I would not; so why am I expecting that position is what will get my loss back? Granted, one could take this philosophy too far and take off any trade that starts to go against them. Well, no, the trades need time to work and they are going to move, often showing a small loss at some point. But the major stinkers, well they’ve had their chance and now they’ve become a bigger risk than I want lying around.
Now, I know market cyclicality is a thing, and that it should work in favor of a trade coming back to profitability. I just haven’t found it to be dependable. Mainly, that’s a timing thing; often the cycle takes months or much longer, and I don’t want to keep a higher risk position around just hoping it will someday come back.
In addition to decreasing the max loss of my positions, I am also planning to take off any trade where an option strike is breached. I had already been tinkering with this idea when a recent Tastytrade study intrigued me enough that I decided to implement it into my plan.
So there you have it. A max loss of 2x the credit received and closing any trades where an option strike is breached—that is my plan going forward. While this will likely decrease my win rate a little (currently 93%), it should also decrease the volatility in my portfolio and, if my assessment is correct, increase my long term returns.