How to Use the “Submarine” Method of Managing Risk in Your Option Selling Portfolio
While managing risk on individual positions is important, managing overall portfolio risk could be more important. Here’s how to manage yours like a pro and keep your ship running full steam ahead
When most investors think of risk management in option selling, they think about individual position risk. Where do I get out? How much do I risk?
While this is important (we covered it in a prior blog entry a few weeks back), a part of risk management many investors overlook is overall portfol. io risk. Part 2 of risk management, and perhaps the more important part, is managing overall portfolio risk. Overall portfolio risk deals with how your portfolio is structured.
A Properly Structured Option Selling Portfolio
Many a new option seller will enthusiastically jump into the game without ever considering one the most (if not the most) important components of a portfolio. That is how the portfolio is structured.
Getting this part right not only makes part 1 easier, it comes with a laundry list of advantages. These include:
- A more solid, risk averse portfolio in general
- A portfolio less vulnerable to “black swan” events in individual markets
- More stable, consistent results
- Adequate and proper diversification
- A portfolio that allows you to sleep at night
Riding The “Submarine” Positioning Strategy to Structure your Portfolio and Minimize Your Risk
As explained in our Investor Discovery Kit for high net worth investors (www.OptionSellers.com/Discovery), we typically recommend investors keep 50% of their option selling portfolio in cash (ie: back up capital).
Thus, if you are keeping 50% of your capital as back up cash, the question then becomes, what do you do with the other 50%. Risk management begins with your initial structure.
The structure you should remember is this: Small positions spread across many markets.
If you’ve ever seen the movie Crimson Tide, you’ll remember the scene where, having wrestled command from Gene Hackman, Denzel Washington finds himself in charge of a nuclear submarine that takes a torpedo hit from an enemy sub. A pipe is severed and the sub starts to flood. After several unsuccessful attempts to fix the leak, he issues an order to “seal the compartment.”
The compartment is sealed off. The damage is contained. The ship stays afloat.
The crew of the USS Alabama keeps their nuclear submarine afloat after sustaining a torpedo hit in Crimson Tide. Learning to do the same with your option selling portfolio can keep your ship sailing smoothly.
A nuclear submarine is divided into many different compartments, each capable of being sealed off from the rest of the ship. In the event of a torpedo hit, the damaged compartment can be sealed off, containing the flooding to one small area and keeping the ship itself intact.
This strategy of risk containment is an excellent example to follow for your option selling portfolio. Instead of taking large positions concentrated in a few markets and focusing on a “where I’ll get out” tactic (that means you S&P traders), it can be infinitely more effective to spread your risk into a series of small positions spread across many diversified commodities markets.
The “Submarine” Strategy of Managing Short Option Risk
The Submarine strategy of Short Option Risk management calls for small positions spread across many different uncorrelated markets. Positions can be further diversified by selling puts and/or calls in these markets. Unlike stocks, commodities markets are less correlated to each other (ie: the price of natural gas has little to do with the price of coffee.) This means a “black swan” event can be better contained to one or few “compartments” of your portfolio. A large cash cushion provides the ability to ride out adverse moves as well as helping to keep position size in check.
If and when a market does move against a position, the loss represents only a small portion of your overall portfolio. It can be “sealed off.” The ship floats on.
Compare that to the S&P trader who goes “all in” on those puts or calls that “can’t miss.”
“It will never go there,” they reason, “so why not load up?”
Because just when you think it will never go there, it does. And when it does, your ship sinks. There is no perfect trade. No sure thing. Anything can happen in the market. Better to expect losing trades as part of the plan and have a system ready to handle them when they do occur.
Proper and effective risk management begins with a good overall strategy. Good overall strategy means good structure. The Submarine blueprint is an excellent starting point for new and experienced option sellers alike.
James Cordier and Michael Gross are portfolio managers with OptionSellers.com – a private capital management firm specializing in Option Selling. If you would like more information on option selling accounts with OptionSellers.com, you can request a Free Investors Information Discovery Pack at www.OptionSellers.com/Discovery
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.