Okay, perhaps the title is a bit over the top. But, if it gets your attention – for real – it’s worth it.
Most investors – especially conservative ones like those using The Monthly Income Machine – know that controlling risk is more important to trading account health than trying to maximize profit. The problem is that many investors – including yours truly in the early days – often only pay lip service to the importance of limiting risk.
The culprit, of course, is the very human desire to avoid taking a loss when a position is going the wrong way.
The solution when trading credit spreads and iron condors for monthly income is to follow systematic entry rules like those spelled out in the Monthly Income Machine, but also to employ sensible exit rules associated with your own MRA (maximum risk amount), whether they are more stringent or more less conservative than those spelled out in the book.
Just consider some basic arithmetic of money management associated with three situations:
1. Limiting Risk
If you employ the trade entry rules of the Monthly Income Machine, you can be statistically confident that 8 – 9 out of 10 trades should be profitable, i.e. the options will expire worthless as you want them to, and the entire original premium profit is yours.
Those winners can be expected to produce 5-10%/month profit on your margin investment. So far, so good.
But, if on 8 successful trades using 10 credit spreads, you average $1,000 profit each, but on 2 losers you allow a $4,000 loss on each, you obviously haven’t made a dime. (You also are obviously not following the “Machine’s” maximum risk guideline).
2. Recovery Hurdle
Now let’s look at some really grim mathematics that investors often lose sight of.
The subject is: recovery. Although this should never, ever, even remotely be an issue for Monthly Income Machine investors, it often is for folks speculating in commodity futures or outright option purchases, two traditionally high risk–high reward markets.
Please remember this: if an investor allows his account value to drop by 50% over some time period, he needs a 100% gain the next period just to get back to even! Seems counter-intuitive, but it’s true. If an $80,000 account drops to $40,000 (a 50% drop), you need a $40,000 gain in that now $40,000 account to get back to even… and that’s a 100% gain requirement.
3. A Dangerous Stop Order
One last “numbers” issue as it relates to risk limitation.
If you read the article on Stop Loss Orders, an important take-away from that white paper article covers the danger of placing an overnight (good-until-cancelled) stop order directly on an option credit spread. Those pesky “numbers” can again cause heartburn.
Imagine that your bear call credit spread was established with a $1.00 premium difference between the long and the short leg. You will therefore make $100 per spread if the underlying stock or index is below the strike price of your credit spread’s short leg at option expiration.
Let’s also suppose that you want your risk-limitation “stop” to be about a $3.00 premium spread between the two legs, i.e. if the market moves substantially against you and the spread difference rises to $3.00, you want to exit from the trade and accept the $2.00 loss per spread… which represents the “Machine’s” $2.00 MRA (maximum risk amount) guideline.
So far, so good. But if you placed that $3.00 stop loss order on the spread as a good-until-cancelled order, you could have a problem.
Let’s say it was an XYZ bear call spread and the spread closed yesterday like this:
Short XYZ Dec 120 call @ $3.60
Long XYZ Dec 130 call @ $2.60
The spread difference is $1.00, and you were still well away from your $3.00 spread difference stop loss order at the end of the day.
But at the opening today the only orders that have been placed yet on the XYZ 120 and 130 calls are “fantasy” low-ball bids and a well above-the-market sell order that the folks who placed them hoped would get filled later in the day if the price of XYZ moved substantially in the direction they wanted.
Here’s the problem (and it’s a big one!): once the market officially opens, even though there may be little or no change in the underlying XYZ stock price when it begins trading, the spread difference between the two legs of your spread still reflect those “dream” orders and exceeds your $3.00 stop order difference! Your stop order gets filled despite the fact that your two options never traded anywhere near your stop price and the underlying XYZ is trading at “unchanged.” You are stopped out even though you really shouldn’t have been based on what was actually happening in the market. Does this actually ever happen? Yes!
The solution, as spelled out in the earlier stop loss white paper, is very simple. Don’t use a good-until-cancelled stop order on options. You either re-enter a day-only protective stop each morning AFTER the market is open and has begun trading, or you use a good-until-cancelled “contingent stop” which is a stop loss order based on the price of the underlying stock rather than directly on the option spread itself.
A contingent stop assures that you will not be stopped out of a position unnecessarily by establishing that “if XYZ stock trades at or above a certain price, then close out my option spread.”
So there you have it. A threesome of investor money management problems that you can easily avoid, and should.
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