Condor Options

Your only trading account is worth $10,000.  You wake up really late tomorrow, and the market has already been open for two hours.  You check on your balance, and discover that the account is up $500 on the day.  Are you:

a) elated
b) pleasantly surprised
c) indifferent
d) a little concerned
e) terrified

We’d go with e) terrified, because if your positions are such that you stand to make 5% in one session, then you probably also stand to lose 5% in one session, and that’s more risk than most people want to (or should) take.  d) is on the right track, and c) is just weird, unless you are genuinely indifferent to worldly possessions (in that case, you should be spreading enlightenment, not trading). b) and a) are recipes for disaster: developing a strong emotional connection to given trading outcomes is one of the fastest ways to blow up an account, since it turns what should be a forum for rational risk-taking into a venue for addictive behavior.  Sure, “terrified” is also a strong emotion, but anyone who exhibits fear (rather than greed) as a result of dramatic gains is probably – and rightly – afraid of having taken on more risk than they intended to.

What if the account was worth $10M, and you made $0.5M that morning?  We suspect fewer people would answer a, b, or c in that instance, since half a million dollars is a lot of money and most people would probably be more concerned about locking in those gains than about celebrating their own accidental genius.  Obviously, the nominal account size doesn’t justify the diverging responses.  But we regularly hear from traders with smaller accounts for whom consistently beating the market (on their own steam) by ten or more percentage points in a year is taken as a given.

There is this interplay between unrealistic expectations and inattentive risk-taking that makes for really fantastic capital destruction.  This is particularly problematic for traders who have suffered big drawdowns recently and haven’t adjusted their intuitions regarding risks and rewards accordingly.  If you’re down 50% on the year and are still thinking about profits and losses in absolute terms that were appropriate 50% ago, then – by definition – you’re taking on twice as much risk and demanding twice as much reward as you were before that drawdown.

In a recent interview, Paul Wilmott suggested a “devil’s advocate” approach to risk management as an alternative to VaR.  He was speaking to the question of institutional risk management, but the principle applies just as well to individuals: pretend that you wake up tomorrow and learn that your account has lost 5% of its value.  How could that loss have happened?  (Or, in our example, how could that 5% gain have happened: over the long run, surprising gains are just as indicative of bad risk management as surprising losses.)  If you can’t come up with any conceivable story, try a 4% loss, iterating the process until you find some x% range in which the worst of the worst-case scenarios could push you.  If you’re trading mostly defined-risk options spreads, this is easy: it’s just the sum of the maximum losses you could incur on your spreads.

As traders, we are all tempted to spend most of our time looking for the next winning trade or the next consistent edge.  But if this market has proven anything, it’s that risk management is often just as important or even more important than any other component of our trading.

[Photo courtesy of flickr user icesabre.]