What does the Swine Flu teach us about options trading?
The recent global spreading of the Swine Flu has brought back fearful memories of the avian flu. In fact at this point in time, other than Mexico, USA, Canada, some parts of Europe, Hong Kong, New Zealand, Australia, Israel, Brazil, Colombia, France and the UK have reported confirmed or suspicious cases. So far, 160 have dead of the Swine Flu.
The only consolation is that the Swine Flu is nowhere as deadly as the
Avian Flu and that its spread has yet to affect stock markets worldwide.
So, what can options traders learn from the Swine Flu incident?
In fact, the Swine Flu incident taught options traders a lot about
containment of danger in options trading or what we call stop loss and hedging.
The Swine Flu has become the global incident that it is now due to an inability
to contain the virus. Most options traders also allow losses to become “global
incidents” in their options trading portfolios because they failed to implement
stop losses and hedges in order to contain the “virus”.
In fact, some options traders transform into pure gamblers by holding
onto options trading positions that are obvious losers. These losses build up
and become a cancer that is impossible to heal. The options trading portfolio
collapse due to the options traders’ inability to contain the initial
“outbreak”.
No other trading instruments in the world offer as many ways to protect
one’s positions as stock
options do. However, very few options traders plan for and execute sensible
stop loss and hedging rules. How can we implement loss controls in our options
trading account before losses become too big to salvage?
First of all, we need a sensible stop loss and position sizing policy.
Having a sensible stop loss and position sizing policy is like having emergency
control procedures during the Swine Flu outbreak. When the virus spreads to
certain predefined level, the WHO declares various levels of alertness with
appropriate actions to be taken in order to contain or limit the spread. This
is exactly the same thing all options traders should be doing. If you are using
a speculative, high risk options trading strategy such as an out of the money
call option, you should predefine your loss tolerance. Knowing how much money
you are willing to lose on each trade and then size the position such that
maximum loss falls within those limits. This is an options trader’s first line
of defense. If a more complex options trading strategy is used where a
significant portion of the fund is committed, such as the various income
strategies, then sensible stop loss policies should be made before the position
is put on. It is recommended that you automate these stop loss policies using
automatic contingent or conditional orders so that you don’t break these
policies on emotion. Like the Swine Flu, it can be hard for governors to call
an emergency when emergency limits are first reached. Emotions do get in the
way and voices in your head cries out “What if I am wrong?”. Such emotions do
nothing but miss the best chance of containing losses. This is why automated
orders are so important in options trading these days.
Just as vaccines can be developed against the Swine Flu virus, hedges can
be implemented to “heal” losing options trading positions. In fact, properly
executed hedges can transform the directional inclination of a losing options
trading position and “nurse the position back to health” as the new outlook
develops. One of the most common methods of hedging used both to limit losses
as well as to recover the health of a losing position is the Delta
Neutral hedging. In a delta neutral hedge, you will bring the overall
position delta of the options trading position to zero or very close to zero
but with a positive gamma by buying or shorting additional options. When a
position is delta neutral with a positive gamma, it will gain in value no
matter if the underlying asset goes upwards or downwards as long as the
movement is significant. This will help to stop the loss from spreading and
slowly recover the health of the options trading position as the new trend
develops.
Yes, losses in options trading portfolios are as deadly as the Swine Flu.
The most critical thing to do is to limit and contain its “outbreak” through
the implementation of stop loss, position sizing and hedging procedures that
are objectively set in stone and implemented using automated orders. Only then
will you be able to save your portfolio from the outbreak of losses that occurs
so much more often than the deadly flu virus.
