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Cheat Sheet #15 Remove and save this page!

Risk Mechanics

Knowing how and when to evaluate and control risk By Mike Hart

Trading is commerce, and commerce is the relationship between the markets’ vast number of buyers and sellers—all aiming to end the day with a profit. Some will win, and others will not.

As in all of the many manifestations of commerce, trading has rules for success. They’re the mechanics that drive the outcome. While these guidelines differ depending on the business, success does not happen by accident.

One aspect of the “mechanics of success” is knowing how and when to evaluate and control options trading risk.

This cheat sheet can serve as a guide on how to approach risk in the options market. The goal is to set realistic expectations through repeatable mechanics, that are rooted in mathematics and statistics.

Mike Hart, a former floor trader at the Chicago Stock Exchange and a proprietary futures trader, specializes in energy markets and interest rates. He’s a contributing member of the tastytrade research team. @mikehart79

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First, understand the potential for loss before entering into a trade.

Next, consider how well you’re prepared for a large and unexpected move. Having an effective approach is essential. These are three key factors:

Following a large move, evaluate positions based on the risk profile and the profit-and-loss statement.

Unchecked, size can pose the greatest risk to a portfolio. These guidelines help maintain consistency:

Primary Risk Controls

Defined Risk Size, Width of Wings

Undefined Risk Size, Delta Exposure

Trade many non-correlated products

Under 60% total at risk for all positions

Portfolio duration greater than 21 days

Always trade small, any single trade should not be greater than 5% of accounts BPR

Keep trade size consistent across all trades

When possible, scale with delta and not contracts

Naked Risk Defend the trade and follow the principles of rolling

Defined Risk No action required. Give it time and let the probabilities play out