Purchased Option Risk Management

The most important strategy when dealing with high volatility and when purchasing options is risk control. Options traders often become frustrated with losses because of a lack of understanding
of time value, volatility, and risk control. Too many times options traders just allow purchased options to fall to worthless when there were clear indications of a need to exit a position earlier along the way. Let’s look at strategies for dealing with purchased option risk through the use of stops, especially in high implied volatility situations. There are two basic forms of stops: hard stops and soft stops. Hard stops are those which can be placed in an order with your trading execution desk or broker. Soft stops are mental stops which must be managed manually. There are also other forms of stops:

• • Monetary stops: This stop is based on the level of risk traders are willing to accept in liquidation value from the option purchase. Most options allow price stop orders, so this is a hard stop position. This is an effective method of controlling monetary risk; however, it does not account for any technical aspect of trading. Monetary stops allow you to maintain a certain level of capital regardless of the market movement. Retaining capital is the priority of the wise portfolio manager or investor in order to make dysfunctional capital available for other opportunities.
• • Price stops: These are typically generated from technical analysis of the underlying asset. The methods for developing price stops vary as much as the traders themselves, but commonly professional traders use chart retracements, support and resistance, technical indicators and points based on the market closes and many other individual methods for developing price targets. Most important with price stops is to remain within your risk suitability for the investment. Price stops can be a hard stop or a soft stop. As a hard stop, the price on the underlying asset is determined through your own technical analysis and system of risk management on the underlying asset. Once you have the underlying price, calculate the theoretical option value at that price and place a good-tillcanceled stop order in the market. This would be most efficiently done with option analysis software.The price stop has positive and negative aspects; it can be an effective means of controlling the risk of being wrong the market in that as the price of the underlying moves away from the option price, the value of the option will fall to the stop-out price and retain the remaining capital. Price stops can also be of help in defending against volatility changes and time value decay because there will be a physical stopping point for the loss. Unfortunately, this can also be a negative in that the underlying asset may not have reached the target support or resistance area set by your stop analysis, and your position will be liquidated regardless of the market movement or potential movement. If you use the price stop subjectively, such as if the underlying moves to a certain
• point, then you will liquidate the option. Subjective stops are fine, as long as you are able to pay close attention to the market and be alerted when the underlying reaches that point and you actually liquidate the option. Unfortunately, most traders using mental stops will second-guess their decision and not liquidate the position when they should or not be near the market when the stop should  have been executed.
• • Time stops: Time stops are an important function of option trading, especially in long-term options or high-volatility situations. Time value decay is constant on option positions, and theta accelerates as options move closer to expiration. To help avoid the risk associated with accelerated time value decay, you may roll options forward to longer terms. The time stop is a set number of days or a date in which the option position will be liquidated and, if still viable, rolled forward to a new expiration month. There is not a physical stop that can be placed on an order for a time stop, so the trade must be managed manually. It is important to evaluate the costs to roll forward versus the potential  reward in the future. Time stops do not typically reduce the risk of volatility change other than that they limit the term of the trade to the period least affected by volatility in typical markets. Options with longer terms until expiration typically have higher vega than their short-term counterparts. When rolling forward, try to find options with implied volatility of the new option position equal to or lesser than the volatility of the liquidating option position.
• • Implied volatility stops: Setting a stop based on changes in implied volatility is another method that cannot be placed in an order, but must be monitored by the investor or portfolio manager as a soft stop. Stock traders commonly use a volatility stop based on the average true range (ATR) over a set period of time, usually from 14 to 20 bars or periods on the chart, which provides a trailing price stop on the underlying stocks. The implied volatility stop is different in that it provides the benefit of the forward-looking power of implied volatility in options over the historical volatility of ATR or standard deviation. Most commonly we look at implied volatility changes with a retracement method that forms boundaries for the limits in changes in implied volatility (IV). If the implied volatility  begins to fail on an option position, then the demand for the option is likely failing. If this is a call option, then the demand for call options has diminished, which may indicate a shift from buy signals to hold or sell on the underlying. If implied volatility reduces sharply over a period of time, this often means that the supply of options offered to the market has increased rapidly resulting from traders trying to liquidate premium and retain capital. With implied volatility stops, it is important to not focus on one single strike price but on an average of the strike prices around your option position in the same month. If there are a large number of strike prices available, then you may need to average several strike prices. The averaging is to smooth the data and deliver a more stable indication of overall implied volatility rather than just one strike price which may be skewed because of a market order or large volume of trades on a single bid or offer. The more strike prices you include, the more accurate your data will be. Traders often focus on individual strike prices as the underlying asset changes price, and they pick strike prices to try to “pin” the underlying price to, but by averaging, you are less likely to be affected by focused demand on a single strike price by a large hedger or fund. For example, if you have five strike prices each with a midrange implied volatility of 42 percent, 47 percent, 39 percent, 44 percent, and 49 percent, then you will add the five volatilities together and divide by 5. This will get a 44.2 percent average IV (221/5  44.2). From that amount, take a look at the underlying current volatility and a recent history of volatility for the underlying asset. If you have the
• data available, establish at least 90-day mean volatility average for the underlying asset. It will be difficult to get this information on the options, so we have to go with the underlying volatility. Hypothetically let’s say that the current volatility (standard 20-day) is at 47 percent and the 90-day
• average volatility is 39 percent. There is an 8-point difference between the current and the mean volatility. You can use this figure as a stop out point for the options. If your average IV drops more than 8 percent, something is going wrong with the volatility picture and it is time to preserve capital. If you do not have all these data available, you can certainly set a target of no more than a 10 percent loss in volatility without the calculations. Remember to average the IV frequently so you know where you are.
• • Trailing stops: An example of a trailing stop is that if you have purchased a call option and the market on the underlying rallies making the option more valuable, the stop is moved up to account for the increased value. With the trailing stop you have the opportunity to retain your original premium if the option value doubles or you will at least have more of the value retained through the course of the trade. The trailing stop does not move any farther than the original risk level for the trade. The downside to the trailing stop is that it will often not allow market fluctuation within a trend unless the stop is positioned a solid distance away in the first place.

The absolute most critical strategy to deal with risk in purchasing options is to have a strategy. Using a physical stop order in the market with a price—a hard stop—removes the subjective mental guessing game and limits an emotional response to a losing position. For the undisciplined or inexperienced trader, a hard stop is the most effective and necessary method of controlling risk. Nothing is worse than having a purchased option position slowly disintegrate into nothing and expire as worthless while the trader operates on hope that the market will recover. Even the most disciplined professional traders fall victim to hope-trading from time to time. There are many strategies for dealing with volatility as we move into writing options and spreads and we will see significant advantages to these strategies in volatile conditions. However, if you are dealing with outright purchase options, you have limited choices so it is important to be paying close attention to the implied volatility and the volatility level of the underlying asset upon purchase and throughout the life of the trade. Remember that implied volatility is the forward-looking volatility indicator and that you should consider that the change you might be expecting in the underlying asset may already be priced into the option you are purchasing. Purchasing call and put options is an excellent strategy for lowrisk profile investors or as hedging strategies for current or future positions. The key to success with purchased options is buying in low implied volatility and with lots of time for the market to make the move you are expecting.