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Hey, guys. I hope you guys are trading well, and you’re all paper trading. I hope you all paper traded before you actually started allocating real money to trades. I have a very special presentation today.
There are four risks to this type of business. I’m going to share all four risks with you today. These risks are something that you really need to keep an eye on as you develop your business. They are not something that are terribly intuitive, but these are the things that I have learned while doing this business, and creating these business opportunities.
When creating an investment business, we manage by the numbers. The numbers are everything. Every business understands what their product is. You have to have a very good, firm foundation of understanding what your product is. In this business, your product is calls and puts. This is the stuff that we deal with, the product that we deal with. We are selling options, and we are buying options. We are a business that buys and sells.
Any time you’re in business, you have risks. The four risks that I am going to talk about today are concentration of risk, overlapping trades, allocation of capital, and finally, over-trading or over-adjusting positions.
Let’s take the first one: Concentration of risk. What I mean by concentration of risk is that you have almost all of your profit potential centered around a single strike price. For example, I currently have on the screen, our portfolio with the symbol IWM, so it’s weighted against the IWM.
As you can see, we have a fairly wide range in which the IWM could move, and we could still profit from this position. If we dig down into this position, I can show you that we have a lot of different positions on. There are all kinds of different positions here.
Concentration of risks means that – let’s say at the 73 strike price, you have a very large position. You sold a number of calls. Size all depends on the capital that you have allocated for this business. Let’s say $5000 is a lot of money to you. If you have $4000 of your money tied up in margin, and they’re all centered around the 73 strike price, whether you have sold them as calendars or you’ve put on different types of spreads or the sale of a vertical spread. If you have all of your risk concentrated around the 73 strike price, what you’re doing is you’re concentrating your risk at that point.
If prices move way down, or they move way up, you’re probably not going to have the same type of profit potential, as if you had a wider range in which you could profit from. That’s concentration of risk. Concentration of risk means having a lot of contracts or size position for you. If your capital allocation for this business is $5000, or $25,000, or $50,000, or $100,000, or half a million dollars – it doesn’t matter. If you have a large position, a position that you would consider large, at a single strike price, then you have concentration of risk. That is very dangerous.
Prices can move dramatically against you very quickly. If you have a concentration of risk at a particular strike price, you’re going to get hurt.
The second thing I want you to be aware of is something called overlapping trades. Let’s take a look at our inventory for the IWM again. As you can see, we have a number of different positions here. We sold most of these – our calendars and double calendars- and we have the 67 put in May. We are short two of those. We are long two of the 67 puts in June. We are short two of the 70 calls here. We are long two of the 70 calls in June.
There are a lot of calendars here, but you can see that they are all basically at different strike prices. There are different options. One is a put. One is a call.
Let’s say you had an idea for an adjustment. You were running up against your breakeven points on your profit picture, and you decided that you were going to go ahead and make an adjustment, in which you were going to go ahead and buy four of these 67 puts, and perhaps sell four of the 69 puts.
You’re going to do this for a credit. On the surface, it sounds like a pretty good idea. But here is what’s going to happen in reality. Since you are short two of the 67 puts, and you buy four of them to protect your short 69 put position, on a vertical spread – actually, what you are doing, is having a net positive two 67 puts. The four that you’re buying will eliminate the two that you are short, and you’ll have a net two 67 puts in May.
That will have unintended consequences for your position. Unfortunately, Think or Swim’s platform will not alert you to the fact that you are overlapping positions. Now, your calendar is no longer a calendar. You are no longer short those 67 puts. You’re not short those two puts anymore. Instead, you are long two of those 67 puts.
So your calendar is now no longer active, and in operation for you. Also, you’re long two 67 puts, when you really wanted to be long four 67 puts, to protect the four that you’re short on, as the 69 put. It’s a very important concept to understand. When you adjust your positions, if you’re short some puts, and you add four long positions to the same option, then in fact, you are net – a different position. It’s very important that you understand that.
The Analysis tab may not help you with that. It’s not going to pop up a little box saying, “Oh, by the way, you’re short two of those 67 puts. If you buy four of those to protect your short 69 puts, you’re going to be net long two puts.”
When making adjustments, make sure that you take a look at your Trade tab. Look and see where your existing positions are. If you’re short positions, make sure that you do not go long on those positions, basically negating your current position.
The third thing that I want to warn you about, and the third risk of this type of business, is the allocation of capital. Allocation of capital means that you have so much capital available to you. In this case, in this demo account, we have allocated about $28,000. All of our cash is about $230,000, but our actual position for this account is $30,000.
Even if you had $200,000, you don’t want to spend $230,000 on opening these positions. If you had $20,000, you do not want to use all $20,000 opening these types of positions. If you have $5,000, you do not want to use all $5,000, opening these types of positions.