Trading options spreads is about risk control. The purpose is to hedge your risk in case you misread the market signals or if something unexpected happens in the market.
There are a few risk-control models that can help you manage your trading account to maximize your profit potential while minimizing risk. These models are the equity risk model, the adjusted equity risk model and the total equity risk model.
Equity Risk Model
An equity risk model considers the level of risk you are going to take in each trade and then calculates that risk using the amount of capital you have in your trading account.
For example, if you have a $30,000 trading account and you are willing to risk 2% on each trade, your total loss risk will be $600 per trade. If you take an option spread position in any given stock, you will make sure that your total downside risk is no more than $600.
So, what do you do if a spread trade has a $2,000 risk, when your risk point is at $600?
The equity risk model acts as a framework to help you make that decision. You can do one of several things.
- Take the trade but exit if it goes against you after hitting a $600 stop loss for the position.
- Avoid the trade altogether.
- Use an alternative option spread strategy to lower the risk profile.
As your trading capital increases, you can increase the level of risk by following the parameters of this model. For example, once your account grows to $40,000, your risk loss of 2% will increase to $800. At $50,000, your risk loss will be $1,000, and so on.
While your risk loss amount keeps increasing with the growth of your portfolio, your relative level of risk as a share of your total trading capital remains unchanged.
Adjusted Equity Risk Model
The adjusted equity risk model is for very conservative traders who want to avoid steep drawdowns and are willing to accept lower returns as a tradeoff for less volatility.
Let us assume that you have a $30,000 account with a 2% risk limit. You encounter a trade opportunity but have an option spread position already deployed. Your current position has $5,000 of your capital tied up, which leaves you with $25,000 of capital left for the newly presented trade opportunity.
With the adjusted equity risk model, you would calculate your 2% risk against the remaining $25,000, not the original $30,000 as you would with the equity risk model.
Your allowed risk amount under the adjusted equity risk model is:
$25,000 in remaining trade capital x 2% risk limit = $500 risk allowed
Every additional trade that you make lowers the amount of money you can risk. If you have enough trades in place, you will reach a point where you will not have any money to risk for new trades.
You should consider using the adjusted equity risk model if you are a cautious trader, a novice trader or both, because this risk model is designed to keep you from becoming overleveraged.
Total Equity Risk Model
This equity risk model is best suited for aggressive traders who like to scale up their trading and returns. However, I must warn that this model is not for the faint of heart.
Using our previous example, a $30,000 trading account and a 2% risk limit will give you a $600 maximum risk per trade — $30,000 x 2% risk limit = $600 risk per trade.
Let’s say you put on an option spread position that takes $5,000 in capital to construct. After three weeks, the option spread position generates a $2,500 profit, which increases your trading account total to $32,500 — ($25,000 trade capital + $5,000 option spread position + $2,500 in profits = $32,500).
You find another trade with potential that has a total risk of $325 if the trade goes bad.
Using the total equity risk model, you calculate the following:
$32,500 in total trade equity x 2% = $650
Using this risk model, you actually can take two positions in the new opportunity.
Can you begin to understand how much money you can make by scaling up this way?
Let me warn you again, however, that this is not for the faint of heart.
I highly advise beginners to stay away from this risk model because it can get you into trouble and wipe out your entire portfolio, unless you really know what you are doing.
Even then, a “black swan” event, such as a 9/11 type of attack, 2008 housing bubble, blackouts and system failures on Wall Street can potentially wipe out your positions faster than you can protect them if you are overleveraged in spreads.
While the upside potential of the equity risk model is enormous, you need a lot of experience to work with this model.
While this might seem like just a brief overview of risk control, it is more than 95% of what option traders probably know, which gives you a considerable advantage and a better chance of becoming a successful options trader.
My advice is to study, learn and use risk control and money management to execute profitable trades. This will allow you to grow your account without losing a lot of sleep. Start with small trades in the beginning and it will pay huge dividends for you later.
While amateurs usually focus on maximizing profit on a given trade, the professionals focus on lowering their risk to make sure that many small gains transform into a significant investment portfolio over a long time.
Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.