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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Everyone wants to talk about the option play that made him or her 1,000 percentMargin and Risk When we refer to risk management, we speak of the ability to handle with a degree of skill the possibility of loss. Of course, when dealing with trading and the market, there are many kinds of risks. Overall, what we are trying to do is make money while at the same time managing the possibility of loss. This definition could be considered the Optionetics motto. Risk management isnt the sexiest of terms; people dont run out and study everything they can on the subject when they hear it. This has to do with the fact that risk management often discusses how to avoid losses, not how to make huge returns. Newsletters and stock-picking sites post claims of high returns on individual plays, but rarely state they controlled their losses with proper risk management. It just doesnt sell. Baseball has taught us that people prefer a home run to four straight base hits, but a knowledgeable coach or trader knows that its the base hits that win games. Everyone wants to talk about the option play that made him or her 1,000 percent. But do these same people tell you about the other five plays that they lost everything on? Of course they dont. Does risk management mean you cant make large returns on your money? No, it does not. It means avoiding risks that do not make sense over the long term. Maybe the most common reason why option traders dont last long is because they take too many risks. Even though they win occasionally, they end up running out of capital before the next home run is hit. Once you are down 5-0 in the ninth inning, that one home run is not going to win the game for you. I believe one of the most helpful concepts to understand is compound interest. Most of us profess to understand this concept, but if we did, we wouldnt be so quick to take the risks we often do. Let me explain this with an example. If I put $1,000 in a trade and it returns 1,000 percent, I now have $10,000. Now that I have this extra capital, I decide to place $2,500 in four different trades, but each of these loses 50 percent of their value. I now have $5,000 left. If I had made just a 50 percent profit on each trade and compounded this growth each time, I would have more than $11,000. This is because of the compounding effect on my money. This is a very rough example. Obviously, taking all your winnings and playing it on one trade is not advised; but the point is that smaller profits that are compounded will create a larger account than risking too much to hit the home run. When was the last time you got a 1,000 percent return, anyway? In order to accomplish this task, too much risk is normally taken. At Optionetics, we teach that hedging in case of a loss is as important as getting out with a profit. None of us want to entertain the thought that we might be wrong about a trade, but the fact is that we will be wrong sometime and we need to be prepared for that event. On every trade we place, we should figure what our risk/reward ratio is. If we are risking $500 to make $100, is that a good risk/reward ratio? In general, the answer would be no. However, it really depends on the probability that the $100 would be made or the $500 would be lost. For example, what if you see an option trade that has a risk of $500, but this would occur only if a stock at 50 drops all the way to 35 in the next two weeks? The odds would probably say this risk is worth the reward because this drop is not likely to happen. This same philosophy holds true when looking at risk/reward of, lets say, 10-1. This looks great, but if the stock needs to move 75 percent in a month to get this reward, is it really a promising risk? Clearly, there is a lot to risk management. The underlying theme is to make certain you analyze the relationship between risk and reward. Understand that taking fewer risks and not holding on for the home run will benefit each of you in the long run. The Optionetics Platinum site has tools to help traders figure probabilities and risk/reward ratios that can make better traders of us all. So before you start visualizing that new car from the profits of one trade, realistically analyze the situation and make sure it really is the best move to make. THE CONTEXT OF RISK When you put on a trade, you need to look at the worst-case scenario to determine just how much your investment could possibly lose. Then you have to decide just how much you are willing to risk$100, $1,000, or $10,000? When professional traders put on a trade, the first thing they look at (if they know what theyre doing) is the risk. For example, if youre a trader with a large bank trading in currencies, youre not trading just $100. Youre trading $10 million per contract. To be able to profitably handle such sums, these traders have to be able to manage their risk. The most profitable trades have two key elements: limited risk and unlimited reward. After all, you can create trades with limited risk all day long, but most of them will also have a limited reward. A $100 risk for a $100 reward is simply not acceptable. No one wants to risk $100 to get $100, even if you win 50 percent of the time. Only if you increase your winning percentage will it be an acceptable risk-to-reward ratio. Would you take a $100 risk for a $500 reward? I would. But how many times are you going to be right? Thats why its imperative to find trades with limited risk and strong rewards with a high probability of being correct. I am frequently asked, What will it cost me to invest? This is a difficult question to answer. The necessary amount depends on a number of factors. The most important factors are the size of the transaction (number of shares/futures or options) and the risk calculated on the trade. As we discussed briefly in an earlier chapter, there are two types of transactionscash and margin. Cash trades require you to put up 100 percent of the money. Margin trades allow you to put up a percentage of the calculated amount in cash, and the rest is on account. Both types of accounts are set up to settle trades and payments for trades, yet they are quite different. With a cash account, all transactions are paid in full by settlement day. Most of the time, the cash is already in the account before the trade is placed. If you bought 100 shares of IBM at $100, this trade would cost $10,000 plus commissions paid out of your cash account. If IBM were to rise to $110, your account would then show an open position profit of $1,000, or a 10 percent rise in the account. Lets take a closer look at margin and how it can help improve the risk-reward ratio. WHAT IS MARGIN? Margin is defined as the required amount of cash on deposit with your clearing firm to secure the integrity of a trade. Most traders and investors prefer margin accounts in order to leverage their assets to produce a higher return. The amount of margin required on every trade is the calculated figure required by securities and commodities regulators, exchanges, and brokers to protect them from default. Margin is the amount required to protect these various parties against your falling off the face of the earth. A margin account allows the trader to borrow against the securities owned. In order to set up a margin account, you are required to fill out additional applications with your broker. You can use the money for anything you want; however, many traders use it as a type of leveraging vehicle with which to buy more stock. Margin accounts allow a trader to extract up to 50 percent of the cash value of securities, or to have two-toone leverage in buying stocks. This means that for every share of stock you own, the brokerage firm will lend you money to buy another share. This doubles your reward, but also doubles your risk. If you buy 200 shares of IBM at $100 using a margin account, this trade will cost $10,000 plus commissions ($20,000 2), since the brokerage firm loans you the money to purchase half of this position. If IBM were to rise to $110, the margin account would show an open position profit of $2,000, or a 20 percent rise in the account, while you still have only $10,000 invested in this position. The margins on futures are significantly lower than the margins on stocks. The increased leverage that futures markets offer has contributed to their rise in popularity. As previously discussed, the margin requirements for futures vary from market to market. These requirements change frequently as the price of the commodity fluctuates. You should check with your broker to determine the current margin requirement for any futures you are considering trading. In most cases, if your trade starts to lose money, you will receive a margin call from your broker, which requires you to increase your margin deposit to maintain your position. When trading a margin account, brokerage firms charge interest against the cash loaned to the trader. The interest rate is usually broker call rate plus the firms add-on points. The rate is lower than for most loans due to the fact that it is a secure loan. The broker has your stock, and in most cases will get cash back before you get your stock back. Keeping your margin requirement low is essential to lowering stress. Many people find it difficult to stay in a high-stress trade. They think about it too much, fretting about how they might lose $5,000. After all, it took them two months to earn that $5,000. Suddenly, theyre out of the game. Lowering your stress gives you a clear mind with which to make good decisions. When you put on a trade, try to keep the cost of capital as low as possible and the return on your investment as high as possible. Maintaining a low margin is the natural extension of limiting your risk. If you are buying options as part of your delta neutral strategy, or doing futures with options, your margins should be pretty close to zero. You will, however, have to pay for the options in full. Now, as the trade starts working, if your futures side makes money, you shouldnt really have to add any more money to your margin account. However, if your futures side is losing money, you may have to. Theres nothing like receiving a margin call in the early hours of the morning to ruin your whole day. If you have a $100,000 account and you spend $50,000 on your options, there is still $50,000 in your account to support a losing futures position. The problem is that in the options market you cannot touch your long option value, although it is probably keeping pace with the futures loss. It is almost like its in escrow. Its there, but you cannot touch it. The only way you can get to it is to exit your position. You may have to add more money temporarily to your account to stay in the trade. If money were absolutely no object whatsoevergo ahead and dream bigthen you wouldnt care if you had to feed your account. Youd probably be better off if your option side was the one working because of the long gamma. For example, lets say you initiate a delta neutral trade with ATM options. As the market goes up, your options are getting longer and longer, which is definitely the preferable position to be in. Unfortunately, for most of us money is not only an object, but also the driving force behind many of our decisions each and every day. When you are choosing which side to concentrate onthe long side or the short side for your futureskeep in mind that you may have to add more money. This is why it is sometimes beneficial to try to forecast market direction. Loans against your securities do not have any scheduled payments. Therefore, you can pay back your loan on your terms. Borrowing from your margin account also has tax considerations if you have stock that you do not want to sell. If the perceived risk of your trade increases, then the margin requirement will also increase. If you have enough money in your account to cover the increased perceived risk, then you wont be required to put up any additional cash. However, if you do not have the cash required to cover this additional perceived risk, then you will get a margin call. A margin call is a call from your broker requiring you to place additional funds in your account. If you do not place these additional funds in your account, your position will be liquidated. (If you bought something it will be sold, and if you sold something it will be repurchased. This will close out your position.) Why should you be concerned about margin? Most new investors and traders rarely consider the margin other than from the standpoint of how much money they have to put up initially. However, an investor or trader should look at margin as a cost of doing business. There may also be opportunity costs incurred by placing a trade. In other words, the best way to make money over the long term is to use limited resources (capital) to achieve the highest return with the lowest risk over the shortest period of time. You may have a chance to put on 10 different trades, each with different risk/reward and timing profiles. Each potential trade should be placed in order of the highest return on capital with the least risk. New investors or traders need time to figure this out. However, once you reach a level of proficiency sufficient to understand and numerically calculate these levels and categorize them, you will achieve your goal of generating the highest return while minimizing your risk. Lets take a look at the established general margin requirements. Then we will explore some examples of capital analysis. |
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