Do I Really Know My Risk?

Sean McLaughlin
March 23, 2023

I mean, do I really know my risk?

Stocks and Futures traders like to talk about how they use stop-loss orders to define their risks, and that’s smart.

A lifetime ago I managed a small, independent hedge fund that traded commodities with a trend-following strategy. This strategy entered positions that I’d attempt to hold for weeks or months (if they were working).

Every position I had on had a resting stop-loss order working in the market, giving me comfort that I knew the most I could lose if I was wrong.

All that comfort I was enjoying changed one day after a trip to my clearing firm’s office in downtown Chicago.

I sat down with one of the firm’s risk managers for a simple “get-to-know-you” chat. He was curious about my trading and just wanted to get to know me a little better and see if there were any ways in which he could help me get to the next level.

We got into the weeds of my trading strategy and he was nodding along in agreement that he was in favor of what I was doing and he thought the returns I was earning were impressive and better than average for accounts of similar size with that firm.

When we got on to the topic of how much risk I was taking in each position, I had my riff on position sizing and trailing volatility stop-loss orders ready to rip.

But then, mid-speech, he interrupted with a show-stopper:

“What happens if any of these positions go limit down/up against you and you can’t exit at your stop loss order?”

I was embarrassed. I couldn’t believe I hadn’t considered this. It seemed like such a remote possibility. But of course, it wasn’t. And this risk manager followed up with all kinds of examples where this happened, in nearly every commodity/futures contract I was trading.

Gut punch. Reality check. He was right. My risk management wasn’t as tight as I thought it was.

I had the illusion of control, and it had worked up to this point. But if the shit hit the fan, I was at real risk of getting chopped up.

This story came back to me recently as I’ve been trading a lot of 0-DTE options spreads in the S&P ETF $SPY.

It occurred to me that with an account limited strictly to defined-risk spreads, it’s easy for me to know PRECISELY how much I can lose in a worst-case scenario. And while I cannot control my daily PnL, I can control what my worst-case drawdown is. Best of all, it’s easy to track — I just have to glance at my “options buying power (OBP).” That is a real-time measurement of what my portfolio would be worth if I lost 100% on my existing positions. Essentially, it’s the cash in my account that Mr. Market cannot touch, no matter what.

My friend (and “Market Wizard”) Peter Brandt likes to talk about one way he tracks his portfolio value for purposes of position sizing is to only track his “closed equity.” Meaning, what’s the value of his account, not including his open positions which are changing in value from moment to moment? This is a conservative approach that keeps him from sizing up too much right before a big open position (paper profits that belong to the market) strongly reverses on him.

In much the same way, tracking my OBP keeps me focused on being conservative and keeps things in a better perspective for me.

So my focus has been on making my Options Buying Power go up on a daily basis. If can succeed in that, then the profits will take care of themselves.

Trade 'em Well,

Sean McLaughlin
Chief Options Strategist
All Star Charts, Technical Analysis Research

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