One of the benefits of being a coach for OptionsANIMAL is that I get to see the paper trading portfolios of our students. To say that I have seen some interesting trades and some interesting portfolios would be an understatement. Most of the time the portfolios and the trades are good and demonstrate the value of learning to walk before you run. However, one area seems to need constant reinforcement and regular correction, more often than I would like. That area is the failure to determine the cumulative effects of secondary exits.
At OptionsANIMAL we teach our students to determine both their primary exit (when to close a profitable trade), and their secondary exits (what to do if your trade does not conform to your initial expectations). Many times the secondary exits require additional capital. Take for example one of the most common trades placed by options traders; the bull put (a spread trade where a put is sold and another put is bought at a lower strike price than the sold put, with both options in the same expiration series). Because the sold put creates the obligation to buy the underlying equity at the strike price of the sold put, a typical secondary exit would be to take ownership of the stock if the sold put were to be assigned. From there, typically we would adjust the stock ownership position into a very common equity-based trade called the collar trade (a strategy that involves buying the underlying stock and at-the-money puts, while selling out-of-the-money calls).
A very straightforward adjustment to be sure. Typically, the initial trade (which could be considered a complete loss), is not only made up for, but a profit may be generated in two to three months. Because of this characteristic of selling a put vertical, the fear of the trade going against the trader is minimal. So, typically what I see happen is that a student will place numerous bull put verticals into a portfolio. The tendency is to have too many put verticals. The danger with this approach is that there may not be enough capital available to follow through on the secondary exits of all (or at least many) of these open trades. It is not question of if the market will correct, but rather a question of when. Since the “when” is unknown, we must always be prepared for that eventuality.
If you plan to own the underlying equity as part of your secondary exit, then you need to ensure that you have enough capital available to actually do so. Furthermore, if you have more than one put vertical in your portfolio you need to make sure that you have enough capital available to follow through ultimately on all of them. Without doing so exposes the trader to the potential for significant loss. Since the trader will not be able to follow through on their secondary exits, they will have no choice but to close trades at a loss! If you are closing trades at a loss it implies that you either have not considered your secondary exits or you have failed to ensure that you have the capital available to do so. Having a plan without the ability to follow through on your plan is no plan at all. You must have the financial capability to follow through.
So how much capital do you really need? Well that’s going to depend on the types of trades that you are initiating and your planned secondary exits. If the secondary exit involves buying the equity you need enough capital to buy the equity. If the secondary exit is to turn it into a diagonal or calendar spread, then you need enough money to buy the longer-term option.
The critical step that many seem to miss is that it is not enough to simply know what the capital requirements are for your individual trade, but you must also add up the capital requirements for all of the trades in the entire portfolio. Failure to do so can lead to disaster. It really isn’t a question of if the entire market will move against your portfolio at some point in the future. It is simply a question of when. Ensuring that you have the capital available to follow through on your secondary exits eliminates the possibility of having to close trades at a loss. So, the professional investor/trader knows that proper portfolio management means that you have to take the time to look at the worst-case scenario for each of your trades and then summarize the entire risk of the entire portfolio. You might be surprised by just how much risk you are exposing your portfolio to. The end result might mean that you need to scale back on the number or size of open positions in your portfolio. At the very least, by taking this extra step you will know that you can in fact follow through on your secondary exits. Without this vital information, you are not ready to trade.
Jeff McAllister is the director of education at OptionsANIMAL. McAllister is a key contributor to new educational content taught by OptionsANIMAL and is also a frequent instructor for optionMONSTER® and tradeMONSTER® in their educational webinar series.