Friday, May 14, 2010

So What is the Real Risk in That Position?

This was to have been written a while back, and in many ways I wish that I had managed to do so before last Thursday’s meltdown. Originally intended to show how a stop loss order is poor protection against an overnight gap, it turns out that the same principles are relevant even to a very steep intraday decline which leaves one unable to place orders; which when we come to think of it, is really no different from a sudden (i.e,. overnight) gap.
In our last write-up, we examined position sizing and how to determine it. In doing so, we used a stop loss as a measure of maximum risk.
Let us recap. (We were talking of a entering a long position).
Account Size = 40k
Maximum risk per position = 2%
Hence our maximum that we are prepared to lose in a trade is 2% of 40,000 = $800.
We then postulated that the maximum tolerable loss per share would be $2.50, so we came up with:
Number of Shares to buy = 800/2.5 = 320.
So buying a round lot, we buy 300 shares, reducing our total risk to $750; if we want to maintain our risk at $800, then we can increase our stop loss to $2.66.
If the details are sketchy, you can always review the first post here: How Many Should I Buy ?

Is That Really Your Maximum Risk ?
There are really only 2 ways to place a stop loss order: either a “Stop Market” order or a “Stop Limit” order.
Let us assume the worst, and say that after you placed this very well thought out trade on the close, you woke up the next morning to see a $5 drop overnight (or alternatively, during the next day, the market took a sudden dive after the manipulators decided to withdraw all bids in a show of force to stop politically inspired reform, or for whatever reason).
Let us take a look at what would happen.
  1. You had a StopMarket order.

    You will be filled at whatever price the market maker decides to fill you, albeit it will most probably be no lower than the bid at the time that you are filled. Remember that you are selling, so a market order is at the bid. Nothing stops the market maker from waiting for a while for the price to drop some more before you are filled. Of course, you can complain to your broker, with screenshots to prove it, and the difference MIGHT be refunded to you.

    The net is that you will probably be filled at a price $5 less than you entered at, a total loss of $1,500 on your account; a far cry from what you had planned.

  2. You had a stoplimit order

    The current price is so far below the minimum price that you are willing to accept, per your limit order, that your order is not filled. You can then choose to wait, smoking copious hopium, or decide to liquidate at market.

    If you choose to wait, then you will get filled at the time that the stock is moving back up, in the original direction that you wanted the stock to be moving. Oops.

    If you are unwilling to take the loss, and move your stop below the current price, you have compounded your probable loss, with only hopium to show for it.
If you are really unlucky, and the stock faced a $40 drop, you would be out $12,000 ! You think it cannot happen? Remember Bear Stearns? OK. So that was a black swan event. Ask those to whom it happened if they care about the color of swans.

Regardless, when you use a stop loss for risk control, the real amount that you have at risk, is the entire position, even if it is a far fetched possibility. The stock CAN go to zero.

So What To Do Instead ?
What if I told you that there is another kind of equity that you can purchase which will ABSOLUTELY GUARANTEE that no matter how far or fast your original stock price dropped, you can sell this new equity at a specified guaranteed price, no questions asked? What this means is that even if the stock dropped passed your original stop loss point, you can just walk away, knowing that you are covered, and you absolutely CANNOT lose more than you had originally planned. No need to worry if you cannot place a trade because there are no bids; no need to even think about how much further the stock can drop.
Does that sound too good to be true? Well, this is one instance when it is not too good to be true. Of course, there is a cost: you have to buy this instrument, thereby sacrificing a part of your profits, most probably, but not necessarily. If it still sounds too good to be true, let me ask you another question. If I said that I could sell you a contract, such that if you had a car crash that damaged your car beyond repair, we would give you money to buy another car, would that be too good to be true? Of course not: you are required to purchase such a contract; it is called “Insurance”.
Well, basically, when you buy car insurance, what you have done it to get the right, under very specific circumstances, to PUT you car into the Insurance Company’s name, and get paid for it. We all know that when the crash happens, the insurance company will go into an “Muhammed Ali Shuffle”, as it tries to find all manner of reasons not to pay up.
Fortunately, when we are dealing with stocks, there is another authority that ensures that the insurance gets paid. By now, you must have figured that that authority is the OIC, and I am talking about PUT options.

So What Are The Mechanics ?
Instead of returning to our fictional company, let us look at a real stock, assuming the same account size and risk parameters.
As we already know how to efficiently trade options, we shall select a stock where we can put that knowledge to use. As always, THIS IS NOT A TRADE RECOMMENDATION: it is an illustrative example. If you are unclear about that, please read the disclaimer at the bottom right corner of this page; then read it AGAIN.
Knowing that everything in this market is bullish, we shall go back to last Wednesday, May 5, 2010 to place out trade, and see how it would have played out. We shall take the ultra efficient IWM for our vehicle. Our data will come from TOS thinkback. Very nice.
Purchase price = IWM MOC @ $69.92
Stop Loss = $67.30, placed $0.09 below the swing low on Apr 1, 2010. As good as any. You just need a good reason to select a reasonable stop.
Therefore, risk per share = $2.62
Risk on account = 2% of 40k = $800
Therefore, Number of shares = 800/2.62 = 305+
We purchase 300 IWM MOC @ $69.92 = $20,976
This means that, basically, half our entire account is in one position. This is clearly not desirable, but it is a great way to illustrate this point, and (later) how to trade the same position without tying up so much of the entire account.
We all know what would have happened on Thursday to our position, so let us not dwell on that. Instead let us see how we could have protected our position better than the stop loss did.
Looking at the June PUT options (ask price, rounded for easy calculation):
June 69 PUT: $2.00
June 70 PUT: $2.30
June 71 PUT: $2.70
In order to determine what our choice is, we assume the worst: the IWM tanks to zero! Of course, we know that is almost impossible. That is not the point. The point is that if this were not the IWM, but a stock, it could go to zero. Remember Enron? If the stock went to zero, we can immediately sell our option for the strike price, if not slightly more.
Let us see what each option purchase then affords us.
  • June 69 PUT
IWM purchase price = $69.92
June 69 PUT purchase price = $2.00
Total outlay = $69.92 + $2.00 = $71.92
Proceeds from sale of PUT = $69
Total loss = $71.92 – $69 = $2.92, a bit more than the planned $2.62, but certainly better than losing the entire trade because you could not get out quickly enough.
  • June 70 PUT
IWM purchase price = $69.92
June 69 PUT purchase price = $2.30
Total outlay = $69.92 + $2.30 = $72.22
Proceeds from sale of PUT = $70
Total loss = $72.22 – $70 = $2.22. Actually LESS than the planned loss of $2.62! And you can hold the trade even while the IWM was tanking.
  • June 71 PUT
IWM purchase price = $69.92
June 69 PUT purchase price = $2.70
Total outlay = $69.92 + $2.70 = $72.62
Proceeds from sale of PUT = $71
Total loss = $72.62 – $71 = $1.62 !!!
So it would appear that using PUT options instead of a stop loss, is at any rate reducing our risk.
That is all fine and dandy, but it does not tell the whole story. Here is the rest of the story. You PAID money for that PUT, so that means that your profits, if the position were to be profitable would be reduced by what you paid for the puts. There is no such thing as a free lunch.
Options pros have a name for the position that has just been created. It is called a “married put”. Married Put = long stock + long option.
How does this affect us?
Let us assume that you have a target of $74 (just under the April 2010 high). We are not looking at the merits of a trade that would have in the first instance appeared to have risked $2.62 (the stop loss) to make $4.08 ($74 – $69.92 purchase price); we are illustrating a principle here. If that is the case, then we assume that you would have sold the position at $74. So, when you liquidate the position, here would have been the various profits.
Profits = Proceeds - total cost of entry
Profits = Proceeds – (cost of stock + cost of put)
Profits = $74 – ($69.92 + cost of put)
  • June 69 Married PUT
Profits = $74 – $71.92 = $2.08
  • June 70 Married PUT
Profits = $74 – $72.22 = $1.78
  • June 71 Married PUT
Profits = $74 – $72.62 = $1.38

Naturally, these figures would look a whole lot better if you had a higher target price.
However, continuing with our $74 target, as we have decided that no matter what, we are getting out at $74, why not then use another equity to ensure that if we breach $74, we are going to get paid $74. Better yet, if we do NOT breach $74, we get paid anyway!
You guessed it: we sell the June 74 Call for $0.96.
Once we do that, we have capped our loss. but we have also capped our profits. Just add the $0.96 to each scenario to see what have. Options pros, call this position a collar. Collar = long stock + long option + short call.
  • June 69-74 Collar
Max Profits = $74 – $71.92 + $0.96 = $3.04
Max Loss = $2.92
  • June 70-74 Collar
Profits =$ 74 –$ 72.22 + $0.96 = $2.74
Max Loss = $2.22
  • June 71-74 Collar
Profits = $74 – $72.62 + $0.96 = $2.34
Max Loss = $1.62

You can calculate the risk to reward ratios for yourself.
That concludes this write up. The only thing left to note is that we have constructed a position where both our risk and our reward are capped, regardless of what happens to the stock. Does that remind you of something else? Remember that even though you have now totally limited your risk, you have still tied up half your account in one position. Even if your total possible loss is small, tying up half your account in one position can hardly be described as efficient.
Our next write up will tackle that question.
As one last parting note, what would be our current position if we had made this trade, and then been forced to sit through last Thursday’s meltdown?
  • At the end of that scary Friday, May 5, 2010 - ~$200 loss after that scary drop and return. And you sat all through it, drinking a latte, while the position tanked way past your original stop loss, but you stopped losing money.
  • At the end of today, May 13, 2010 - – position has returned to profitability, and all because you did not get stopped out by that insane market downturn.
Finally, the 71-74 collar shows a total per share risk of $1.62. The question then arises. Should we increase our position size to 500 shares, so that our risk is just a shade above the $800 we talk about? Well, we could, but then our cost of entry has gone up to $72.62, meaning that we would be using $36,310 for the position. For all practical purposes we would have tied up our entire account in one position. Oops.

- Authored by Osi
blog comments OCCASIONALLY powered by Disqus