Are There Lessons to Learn When Options Risk Controls Backfire?

Hindsight has the ability to be an investor’s best friend and also his greatest foil. This was no more evident last Wednesday, when the S&P dropped 32 points on the open to eventually come all the way back to even, and then actually close positive by the day’s end. This was this first time in seven years that a 1.5% intra-day swing like this had occurred. And we can only say we’re thankful that it is such a rare event.

Looking back at what happened, one comforting aspect was that we at least knew what caused the decline, namely the decision by China to devalue their currency. Knowing now how the day would end, it is obvious that investors or traders who did absolutely nothing would have sailed through the day with a modest profit.

But that is not what any option trader serious about risk management should have done.

Active risk management has to be at the heart of any option trading strategy. As an options trader, when your positions start to contain more risk than you are comfortable with, you must take action to reduce that risk. You must have rules in place, and you must follow those rules.

On Wednesday, options traders were presented with a choice. After a 1.5% drop on the open, you could have done nothing and hoped that the market would stabilize or rally; or you could have closed out the positions at the then current prices and prevented any further losses.

If you are trading with your own money, you may be comfortable rolling the dice and hoping that a 1.5% drop on serious news doesn’t turn into a 3% drop minutes later. But when volatility is spiking, options prices are doubling, and you are entrusted with the prudent management of other peoples’ money, your clients probably didn’t sign up for a game of craps.

Our years of experience have taught us that when risk is increasing, we act to reduce that risk rather than hoping that it will go away. Too many traders have been carried off the trading floor because the market did not do what they hoped it would.

Of course, reducing risk as the market was sinking would have turned out to be exactly the wrong thing to do. You would have taken a hit, but neither you nor anyone else could have known that. There was an equal chance that you might be looking back with hindsight, patting yourself on the back as the market sank lower.

Is there a lesson to learn here about what to do when risk controls backfire?  We don’t think so. Clearly there is a risk that they won’t work, but one can’t know that at the time. Any options trader should rather be safe than sorry. Yes, you would have lost money, but you would have stuck to your rules, responsibly managed your risk, and done right by your clients.