Swine Flu and Options Trading

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.