lystn

Hey everyone, Kirk here again and welcome back to the daily call. Today, I’m going to answer a question from one of our users on Twitter who sent this in which I appreciate. Again, you can reach us through Facebook, Twitter, Instagram, however you want to get your question in. Just get it in, so we can get it added to the queue here. But the question was, “How do you monitor an option trade’s risk after making adjustments?” The idea was, “Okay. If I know that I have a 1% risk on entry, whether I'm doing it based on margin requirement or whether I’m doing it as a fixed defined risk spread, so the spread I know is $2 wide as an iron condor or $5 wide as an iron condor and that represents 1% of risk in my account. I know that on entry, but what happens after I start adjusting? How do I monitor that risk in the trade?” I think it’s actually pretty easy and I’ll talk about two concepts here in today's daily call because I want to touch on both of these. The first is that if you are trading defined risk strategies, then monitoring your risk after an adjustment is still as simple as making sure that you understand where your widest spread is because on defined risk strategies where you’re doing a spread, you’re selling one contract, you’re buying another, risk is always based off of the widest spread. You can do an iron condor and have a $3 wide spread on the put side and a $3 wide spread on the call side. Now, the widest spread on either side is $3. If you do something that’s a little bit skewed, maybe you do a $5 wide spread on the call side. Well, your risk is going to be based off of that widest spread, that $5 wide spread. If you start making adjustments, as long as your spread width doesn't increase, meaning you don’t increase the width of a spread, then your risk is still going to be the same. It’s still going to have the same potential to lose money or whatever the dollar figure is that you have as risk. It’s still going to have that same 1% if you targeted 1% on trade entry. That doesn't change. When you go to a margin-type scenario where you’re trading short strangles, short straddles, we based risk based off of the initial margin requirement. And so, that means that if we make an adjustment to a trade, that maybe our margin requirement either goes up or down. We could adjust into a position that actually requires less capital because of where implied volatility is and where we are in relationship to expiration. I usually air on the side of caution with short positions that are undefined risk straddles and strangles and I always tell people, “You want to enter those with a lower percentage allocation on entry, knowing that you might just have to hold more capital in the future if you need to make adjustments.” Most of the trades that we do in that realm, around the 1% to 2% as the initial entry, so even if we get into a couple of laddered positions, they’ll still never make up more than 1% to 2% of our account. The reason is because if we have to make an adjustment, then we might have to hold more capital in margin to cover that position. Now, that doesn't mean that it's going to lose money. Just holding capital and margin does not mean that that's going to be the money that you lose. It just means you have to hold more money in margin. And we just want to have the room in our portfolio, the flexibility to be able to hold that margin and make an adjustment because adjustments do help reduce risk. They increase our credit, they give us more duration in trades and they ultimately end up making us more successful. We want room in our portfolio to make those adjustments. Now, getting back to defined risk trades, you could also make an adjustment that widens your spread width. If you make an adjustment that widens your spread width, maybe you roll down a call option and go from a $5 wide spread on the call side to a $7 wide spread on the call side. Just understand that your risk is now based off of the $7 spread as opposed to the $5 spread that you had originally. Again, it’s very easy to make adjustments and monitor those because it’s all based on spread width or margin requirement. Again, getting back to just the basics of trading, the fundamentals of trading – Keep your trade entry small to begin with until you understand how to calculate a lot of this. I suggest like this person did on Twitter and I think this was great. They started with 1% risk and then left them lots and lots of room to either allocate more to it if they needed to or to adjust into a position that required more capital just for holding purposes during that time period. And so, I think you start small and then go higher if you need to as far as the allocation versus trying to do it the other way. Trying to start at 5% or 6% allocation and then trying to ratchet it back and adjust at the same time probably doesn't work out all too well or at least, you could get yourself into a situation where Murphy's Law takes hold and something that will happen bad ends up happening bad and that creates a nice little drawdown in your account which you didn't want in the first place. As always, hopefully you guys enjoy these. If you have any comments or questions like this person did, again, reach out to us, shoot us a message on Facebook, send us a tweet, reach out to us on Instagram, wherever you want to connect with us. We would love to know what your guys’ questions are at options trading, so we can get it queued up for the daily call. Until next time, happy trading!