Lesson in Risk Management: 3 Days, +30% Movement in UOA Essential Trade Ideas

How do you risk weight options positions? And what benefits can that have to your portfolio?

Let’s take a look using the two trade ideas from this week’s Unusual Option Activity Essential service — a long PLUG call option and a long MOS put option.

By looking at these, the trigger levels, and the performance of the options over the past three days, we can come to a trading truth: risk-weighting positions is essential.

The trade ideas

Every Tuesday following the members-only webinar, Chief Options Strategist Ryan Mastro and Options Analyst Wayne Razzi send out an email alert identifying the trade idea of the week (or in this case two ideas) for UOA Essential members.

Here is the trade alert from October 12, when the team identified unusual options activity in Plug Power ($PLUG) and Mosaic Co ($MOS):

As you can see, Ryan and Wayne share the unusual activity and present members with a potential strategy to consider.

For PLUG , they give a trigger level of $29.27 that would confirm price should move to the upside. In this example, if price broke above $29.27, then they suggested entering a PLUG 22 OCT $29 call for $1.50.

Similarly, for MOS, if the price broke below $41.00, then they suggest entering a MOS 29 OCT $40 put for $1.05.

Each trade would be stopped out if either the option lost 50% of the premium or if the stock crossed back below or above the trigger level. Therefore, the total losses per contract would be $0.75 for the PLUG trade or $0.53 for the MOS trade.

Why risk-weight positions

Obviously, these losses are uneven. If you buy one contract of each, then you risk $75 per contract ($0.75 x 100 shares) in PLUG and $53 in MOS. This discrepancy rises the more your standard number of contracts is. For instance, if you buy every position at 15 contracts, then your PLUG risk is $1,125, while your MOS risk is $795.

If, however, you trade these as a portfolio where positions are risk adjusted, then you adjust the number of contracts that you buy for each of these positions based on the potential risk. This gives a much more holistic portfolio view and, frankly, is how professional money managers look at position management.

How do you risk-weight positions

From a portfolio view, the easiest thing to do would be to pick a risk unit for the unusual options activity strategy. Essentially that is a max loss per trade idea that you are willing to accept. In this case, let’s say that your max loss per trade idea is $1,000. You would take $1,000 and divide it by the loss per contract ($53 or $75) to find out the number of contracts that you buy of each.

This means you could buy up to 19 contracts of MOS and 14 contracts of PLUG for an equal risk weighting. Your total risk would be $2,057 — $1,050 in PLUG and $1,007 in MOS. (Since you can’t buy portions of contracts, you always have to round this analysis so that it’s similar.)

If you are entering the positions at the same time, you can also divide the maximum $75 PLUG loss by the maximum $53 MOS loss — which gives you 1.4 MOS contracts per PLUG contract. Then, you can decide based on your personal portfolio how many contracts of each you will buy, purchasing roughly 1.4x more MOS per each PLUG contract.

The chart below shows what the analysis would look like. The third column shows that ratio:

Analysis of the result: +30% return in 3 days!

How did these trades perform? At writing — noon CT on Friday, October 15 — the $29 call in PLUG is trading at $2.93 — a 95% return on risk at present. The $40 put in MOS is trading at $0.55, which would be the max loss and require exiting the trade.

As a portfolio, however, these trades are up a whopping 30%. All in three days.

Yes, in this case, the trader would have benefitted if they bought the same number of contracts of both. Instead of being up 30%, they’d have profits of 68%.

However, what would happen if the returns were reversed and the PLUG trade lost the max of 50%, while the MOS trade gained 95%? The portfolio of trades (MOS + PLUG) would be up just 15%. That outcome is clearly not as favorable.

The bottom line: all trades are not winners. Anyone who suggests that every position will be a winner is either a scam artist (aka Bernie Madoff) or a liar (aka Twitter finance gurus). We are neither. We don’t know which trades will be winners or which will be losers — even with unusual options activity. If you are trading unusual options activity, then we believe that you should trade it as a strategy within your portfolio. That means equally weighting positions based on risk.

If you’re striving to learn the basics of what unusual options activity is all about, check out UOA Essential. It’s just $99 for the month with no obligation to continue.

*Individual results may vary. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. Market Rebellion is not giving investment advice, tax advice, legal advice, or other professional advice.