5 Option Risk Management Rules

There’s a saying that goes “no guts, no glory” but in options, it’s the trader who doesn’t take big risks who wins, says Steve Smith of Minyanville.com.

Risk management may seem like a complex topic, in reality it comes down to a few key points—make a plan, make sure your trades are the right size for your risk threshold, and make sure you fully understand the plusses and minuses of the strategy chosen. And always, always have an exit strategy.

Ask anyone in any field—business, sports, medicine, or the arts—what it takes to achieve measurable success and without a doubt, they will mention consistency. A good definition of consistency is the ability to produce above-average results over a long period of time. For the most part, those that occupy the various "Halls of Fame" did it through a lifetime of above-average achievement.

Taking big risks may be exciting for near-term glory, but long-term success, particularly in investing, is an outgrowth of properly managing risk. And by avoiding situations that can lead to complete failure, we put ourselves in a position to succeed.

Allocation Flows Downstream
The concept of asset allocation is the big tree under which all investment strategies should operate. Allocation can be boiled down to "don't put all your eggs in one basket." This is a very simple way of looking at the issue, but it is crucial to appreciate it. And it is a concept that flows downhill. By this I mean, one shouldn't have his or her entire investment portfolio in just equities, but diversified across various asset classes such as bonds, real estate, and commodities. Ideally, there should be an element of diversification within each asset class.

Most people will have a preponderance of equities, but within that base, make sure a variety of sectors are represented. Holdings like Apple (AAPL) and Google (GOOG) can represent technology, while ExxonMobil (XOM) can give exposure to energy, and Coca-Cola (KO) to consumer staples. And obviously, no one sector should represent too big a piece of a portfolio.

It's also important to watch for overlapping holdings, particularly if you own both stocks and ETFs and/or mutual funds. For example, Apple represents about 20% of the PowerShares QQQ ETF (QQQ), meaning that if you own both, it's important to be aware that your exposure to the unblemished fruit is magnified.

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Theoretically, a well-balanced and diversified portfolio will help minimize large swings or losses during times of volatility. But as we have seen in recent years, the market, especially during downturns, has become incredibly correlated. The bursting of the housing bubble didn't just take down housing and financial stocks—all asset classes, including commodities and many fixed-income instruments pretty much fell uniformly.

Options into the Breach
So what does all this basic common sense about diversification have to do with options? First of all, options, especially through the prism of volatility, can certainly be viewed as a distinct asset class. As such, they can be used to hedge or protect your overall investment portfolio. This can be done through basic put or put spread purchases using popular ETFs such as the Spyder Trust (SPY), which mimics the performance of the S&P 500.

What we want to look at is how options can fit into your overall investment portfolio as a means to boost returns and/or reduce risk. Given their leverage, an options-based portfolio can easily be the tail that wags the dog.

So here are some basic rules of thumb for managing the risk of an option portfolio:

• Do not let options positions exceed 15% or 20% of your overall risk capital.

• Only 50% of an option account should be at risk in the market at any one time.

• No single position should represent more than 5% of the options portfolio on the risk side. So if a position turns out to be a total loss, the overall drawdown on that particular trade would be 2.5% (5% of 50% is 2.5%).

• Set price targets and stop loss prices that have probabilities in your favor.

• Trade the strategies that you are comfortable with. To this day, I don't trade VIX products like the Credit Suisse 2X VIX (TVIX) or double leveraged products because I'm simply not comfortable with their construction and behavior. No one asked Pete Rose to hit homers. He wasn't good at swinging for the fences, but he sure could hit singles. If you're a grinder, work on covered calls and vertical spreads. If you're Dave Kingman, try to knock one over the pyramids. Maybe these aren't the best examples as neither are Hall of Famers for different reasons, but you get the idea.

So once again, the bottom line is that managing risk is about having a plan, understanding your risk threshold, and being fully aware of the plusses and minuses of the strategy chosen.

And always have an exit strategy—for better or worse.

By Steve Smith, Contributor, Minyanville