Trade The Journey

Trade The Journey

The Importance of Risk Management in Trading: Strategies and Tips

Welcome to Trade the Journey! Make no mistake, the current economic environment is treacherous. Even the most experienced market professionals are having a tough time deciphering some of the latest market moves and management.

One minute, the market is rallying amid rising treasury yields and the next minute the market is pulling back in response to the idea that higher rates may persist longer than originally thought. Treasury yields usually move inverse to stocks meaning as yields rise, typically stocks pull back.

But this relationship doesn’t always hold true as we saw in the early stages of the Pandemic. So, what’s a beginning trader to do when markets are moving contrary to what traditional relationships suggest?

Well, you could wait for some clarity as some market professionals are doing, keeping their money on the sidelines in high-yielding treasury bills. However, volatility can be a trader’s best friend because of the short-term erratic moves of the market. It’s been a month since I put a trade on after a series of losing trades. It wasn’t fear that was keeping me out of the market. It was my inability to break a central tenet of my trading plan, no trades are placed without completing my homework also known as due diligence.

Being that this article is about trader risk management, what better way to share my knowledge than placing and reviewing an actual trade?

Looking for a trade:

This is by far the most challenging aspect of trading for me. With so many moving parts in the economy and markets, finding a trade that has a high probability of working is difficult, so most of the time I choose a trade that I think has the best chance.

With volatility rising, options are going to be more expensive, and depending on where you think the market is going, your options position may move more than you anticipated. My first choice was to look at the energy market being that China is in the beginning stages of reopening. Although it is looking to be an uneven recovery, China could return to consuming 800,000 barrels if demand fully returns. There’s also OPEC+ which has not changed its output and of course, there’s Russia pledging to cut production.

Recently, the white house pledged to fulfill its goal of selling oil from the strategic oil reserves once oil prices stabilized. The current sales will amount to 26 million barrels of oil. Currently, the strategic oil reserve is well below its traditional levels.

Looking at the charts, which I inserted below, crude oil has been on a sideways trend for the past few weeks. It doesn’t seem like Crude will be rallying anytime soon, in fact, it looks like Crude will be traveling between resistance and support levels.

Maybe I can capitalize on a short-term continuation move to the downside. I don’t want to trade crude, so my best bet might be to find a company that is in the energy sector.

I chose Marathon Oil (MRO) because I am familiar with the stock and the option prices for puts are not too expensive even though volatility is a little higher but not by much. My choices are:

$25.50 at-the-money put: Price: $0.48

Expiration Date: 02/24/2023

Implied Volatility: 48.54%

Delta: -0.52

Gamma: 0.37

Theta: 0.09

Vega: 0.01

$26 in-the-money put: Price: $0.80

Expiration Date: 02/24/2023

Implied Volatility: 48.86%

Delta: -0.69

Gamma: 0.33

Theta: 0.07

Vega: 0.01

The put/call ratio is around 0.473 meaning that puts haven’t been brought in exceeding amounts which is evident by the sideways trend MRO has been in. A ratio above 0.70 is more indicative of put buying.  I think I might be able to capitalize on a small move to the downside.

Important: This is a one-week expiration, meaning that theta will pick up as the option gets closer to its expiration date. All options expire in-the-money or out-of-the-money meaning it’s either a delta of zero or a delta of 100. When volatility rises, it causes the options Greeks to change. These positions are vulnerable to theta, and gamma. My gamma is a bit higher on the at-the-money option but the volatility is lower as well. So, what’s better to buy?

Price targets:

Exit: $26.60 (200 Simple Moving Average)

Profit Target: $24.76

Emotion:

Nervous: This trade might not work, and I’ll lose again.

Uncertainty: Maybe I need more information to put on the trade. Is there a better trade available? Will I stick to my exit or let the trade transform into a bigger loss? Will I close the position once I reach my profit target?

I put on the trade for an at-the-money option. The bid-ask spread was $0.45-$0.48, so I placed my trade close to the bid at $0.46. The position might be filled or there’s a good chance it might not be depending on how the market opens. The first test for me will be, do I chase the market and move my entry price or wait for the market to come to me?

Day 1

Emotions:

Unsure: When the market opened, MRO staged a short rally alongside the rest of the market. It looked like MRO would test the 200 SMA level quickly and I wasn’t sure if I should close the position. My first thought when MRO rallied was, “Here we go again”.

Maybe I should close the position, I thought to myself. When I listened to the analysts speak about the current market action, they mentioned that the previous day featured a big sell-off which added even more doubt. I didn’t close the position, I decided to wait.

Satisfaction: Most of the indices began to sell off mid-morning and my options position was in the green. I felt satisfied and was happy that I didn’t close the position. Maybe this was the beginning of a string of profitable positions. I watched the options position closely, as the gain transformed from a 2% loss to an 8.73% gain.

Doubt: As the trading day progressed, the market staged a small rebound and MRO gained back some of its losses. It ended the day with a doji, which symbolizes an almost fair fight between the bulls and bears. MRO drifted up and then sold off then it drifted down towards $24.76 and buyers stepped in.

You may be asking yourself, what does this half to do with trading and my response would be, “Everything.” Emotions aren’t often talked about in trading. Most of the time, technical patterns, indicators, and a host of other tools to help forecast market action are most often talked about when it comes to trading.

However, your emotional state should be closely monitored when you’re in the trade. I completed the homework the night before but the most challenging part is managing the trade while you’re in it and your emotions play a big part in successful trade management.

Let’s look at the Greeks:

Volatility has risen 5.68% above its average, meaning there is a higher chance that this at-the-money put may end in-the-money. As volatility increases it affects the options Greeks. The price also fell $0.25 which helped this position as well.

If you would like to calculate the gamma, take the closing price from the day before minus the closing price today and divide it by the difference in the delta.

D1-D2/P1-P2

Day 2 Prep:

Initial claims which measure the number of people following their first claim for unemployment insurance will be released tomorrow. The second GDP revision will also be released tomorrow. Both reports will be scrutinized, for an increase in the number of initial claims and an economy that is slowing but in the right way. Both reports have the potential to move the market.

I see several scenarios occurring tomorrow. One is that the market shows a slight recovery, and MRO moves up toward the 200 SMA which is my exit level. The other is MRO moves to retest today’s low and that is where the fun begins.

The decision: If MRO tests it’s low should I close the position or see what happens? My position will lose a little being that an increasing theta will affect the value of the option. There’s one more day before expiration, so I’ll be looking to close the position especially if MRO tests its low on the open.

Day 2:

The Greeks:

Emotions

Anger: I checked the market before the opening and it didn’t look good. I then checked MRO on the 5-minute chart to get an idea of how MRO would open and it didn’t look good. MRO was set to gap up on the open and it did. As soon as the market opened, I was down 27%, losing all of the profit from the day before. I had a choice, I could panic and close MRO or wait to see how it played out. I kept the position open.

Panic: As the morning proceeded, MRO slowly made its way back toward its opening level. I had a chance to close the options position without taking a loss, so I quickly placed a limit order at $0.46. The only problem was, MRO was taking a bit longer than I expected. I didn’t want to take a loss for many reasons. For one, this would mark my fifth losing trade in a row and second, I didn’t want to write a blog post about a losing position.

In my haste to close the position, I accidentally opened a second position. I just couldn’t figure out what I was doing. So now, I had to close two positions. I closed both positions at a loss. It wasn’t a huge loss like I would have faced if I had closed the position at the open but it was still a loss.

Regret: As soon as I closed the position, MRO retreated to its low of the day. I could have remained in the position and closed the position with a small profit. I felt the pain of knowing I closed the position too early for most of the day. However, looking at the charts now, MRO rebounded, and had I stayed in the position, I would have suffered a huge loss.

This article reflects the true challenge of trading, managing your emotions, having your entry and exit levels set before you enter the position, and knowing when to exit a position. As you can see, it’s difficult to know when you should close.

If I had remained in the position, who’s to say I would have closed the position at the low of the day? It’s entirely possible I would have remained in the position to add a few more dollars and would have suffered a loss as MRO rebounded later in the day.

Leave a Comment

Your email address will not be published. Required fields are marked *