To The Moon

Today I'd like to talk about risk control.

No investment system is complete without a risk control component.

It's particularly important to sell put as it has a limited return, but losses (in extreme cases) can reach tens or hundreds of times.

Section I: How to Control Risk Technically

1. Cash-secured is rule No.1.

If you fail to do this, you could lose a lot of money due to margin fluctuations. To learn more about cash-secured, you can click Options Insights III: What is Cash-Secured Puts (TSLA, QQQ, PDD).

2. Sell put spread

Spread means you can sell otm put, and meanwhile buy put at a lower price. The two orders form a combo in your portfolio.

For example,

I can sell $Tesla Motors(TSLA)$ put at $770 and buy $Tesla Motors(TSLA)$ put at $740 for protection.

Let's say 

• when you only sell put: if $Tesla Motors(TSLA)$ plunges to 0, you need to buy 100 shares at $770, then you lose $770 per share.
• when you sell put spread: apart from $770 short put, you buy put at $740, so you lose up to $30 per share.

In practice, this operation is not only used for risk control, but also to improve your return.

A put spread will require less margin than a one-sided sell put (Tiger currently supports option portfolio margin).

Although buy put sacrifices some of the gains, the combined yield is improved with lower margins.

3. n-fold stop loss method

It I sell put of $Apple(AAPL)$ at $120 expiring in October, I can gain $0.5. So I can set an n-times stop loss line.

For example, when n=4. Then if the gain of put goes up to $2, then I close the position and stop loss.

(When the gain of sell put goes up, the stock price is plunging and you may suffer from margin fluctuations)

How to set n?

1) Mathematical expectation > 0

Assume in the long term, your win rate of sell put is x.

Then the formula is win rate * average success gain - failure rate * average failure loss > 0

x - n * (1 - x) > 0 →  n < x / (1 - x) . 

If the success rate is higher, the value of n has more leeway.

2) N should fit your own strategy

• n can not be too large, which means no stop loss.

If the mathematical expectation can not be greater than 0, a loss once will be exceed dozens of wins.

• n can not be too small, which can not survive the volatility.

Even you choose the right strike price and the underlying stock, but a too small n can't survive a small fluctuation.

Different prices (otm), underlying target, and iv, need different n.

3) Calculate based on past experience

A good way is to look at your past successful sell puts and record the minimum n for each one.

That is: n = the highest price of the subsequent put / the price you sell put

After recording a bunch of n's, you can choose a suitable value. This value can meet the conditions we stated above: it can meet the mathematical expectation > 0 and can also help you survive the small volatility.

As a reference, I set n=2.5-4.

Section 2: Train your mind

In fact, the technique is simple, but your mind is hard to control.

The risk control of the options is much more difficult than trading the stock.

There are quite a few things about this strategy that go against human nature.

• Earnings of each contract is limited, so you need to have patience to earn small money from every trade.
• You need to buy another put for protection, and offset part of the earnings.

So mentally:

1. Do not brainwash yourself by only reading the articles that support your opinions.

If evidence shows that you picked the wrong underlying target or price, you should promptly stop loss.

When encountering long-short divergence, you can't just listen to the arguments/articles you want to know, repeatedly brainwashing yourself is meaningless.

2. Avoid fluke mind

Investors should strictly implement the plan and the laws they set for themselves.

Even if you find out afterwards that you shouldn't stop losses, you have to follow the operational discipline next time.

It is more important to follow one rule than the success or failure at one time.

Bottom Line

Finally, there will always be times when we make mistakes, and there will always be black swans in the market. 

Good luck to all of you and hope we can follow our own rules.