Seeking Alpha

How To Use The 'Submarine' Method Of Managing Risk In Your Option Selling Portfolio

by: James Cordier
James Cordier
Medium-term horizon, hedge fund manager, commodities

While managing risk on individual positions is important, managing overall portfolio risk could be more important. Here's how to manage yours like a pro and keep your ship running full steam ahead.

When most investors think of risk management in option selling, they think about individual position risk. Where do I get out? How much do I risk?

While this is important (we covered it in a prior blog entry a few weeks back), a part of risk management many investors overlook is overall portfolio risk. Part 2 of risk management, and perhaps the more important part, is managing overall portfolio risk. Overall portfolio risk deals with how your portfolio is structured.

A Properly Structured Option Selling Portfolio

Many a new option seller will enthusiastically jump into the game without ever considering one of the most (if not the most) important components of a portfolio. That is how the portfolio is structured.

Getting this part right not only makes part 1 easier, it comes with a laundry list of advantages. These include:

  • A more solid, risk-averse portfolio in general
  • A portfolio less vulnerable to "black swan" events in individual markets
  • More stable, consistent results
  • Adequate and proper diversification
  • A portfolio that allows you to sleep at night

Riding The "Submarine" Positioning Strategy to Structure your Portfolio and Minimize Your Risk

As explained in our Investor Discovery Kit for high net worth investors, we typically recommend investors keep 50% of their option selling portfolio in cash (i.e., back-up capital).

Thus, if you are keeping 50% of your capital as back-up cash, the question then becomes, what do you do with the other 50%? Risk management begins with your initial structure.

The structure you should remember is this: Small positions spread across many markets.

If you've ever seen the movie Crimson Tide, you'll remember the scene where, having wrestled command from Gene Hackman, Denzel Washington finds himself in charge of a nuclear submarine that takes a torpedo hit from an enemy sub. A pipe is severed, and the sub starts to flood. After several unsuccessful attempts to fix the leak, he issues an order to "seal the compartment."

The compartment is sealed off. The damage is contained. The ship stays afloat.

crimson-tide

The crew of the USS Alabama keeps their nuclear submarine afloat after sustaining a torpedo hit in Crimson Tide. Learning to do the same with your option selling portfolio can keep your ship sailing smoothly.

A nuclear submarine is divided into many different compartments, each capable of being sealed off from the rest of the ship. In the event of a torpedo hit, the damaged compartment can be sealed off, containing the flooding to one small area and keeping the ship itself intact.

This strategy of risk containment is an excellent example to follow for your option selling portfolio. Instead of taking large positions concentrated in a few markets and focusing on a "where I'll get out" tactic (that means you S&P traders), it can be infinitely more effective to spread your risk into a series of small positions spread across many diversified commodities markets.

The "Submarine" Strategy of Managing Short Option Risk

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The Submarine strategy of Short Option Risk management calls for small positions spread across many different uncorrelated markets. Positions can be further diversified by selling puts and/or calls in these markets. Unlike stocks, commodities markets are less correlated to each other (i.e., the price of natural gas has little to do with the price of coffee). This means a "black swan" event can be better contained to one or few "compartments" of your portfolio. A large cash cushion provides the ability to ride out adverse moves, as well as helping to keep position size in check.

If and when a market does move against a position, the loss represents only a small portion of your overall portfolio. It can be "sealed off." The ship floats on.

Compare that to the S&P trader who goes "all in" on those puts or calls that "can't miss." "It will never go there," they reason, "so why not load up?"

Because just when you think it will never go there, it does. And when it does, your ship sinks. There is no perfect trade. No sure thing. Anything can happen in the market. Better to expect losing trades as part of the plan and have a system ready to handle them when they do occur.

Proper and effective risk management begins with a good overall strategy. Good overall strategy means good structure. The Submarine blueprint is an excellent starting point for new and experienced option sellers alike.