Trading your option portfolio like a hedge fund
by Dennis Chen from Smart Income Partners, Ltd.
A hedge fund manager must have the discipline to follow a plan and make good decisions. Trading your option portfolio like a hedge fund will make you a better trader.
Why do I say this? I've worn both hats. I've been both, an individual trader and hedge fund manager. Currently, I manage a hedge fund that specializes in option income strategies. I've noticed that before I managed the fund, when trading my personal account, I thought I was disciplined. However, I would sometimes take trading liberties (made exceptions) that ended up costing me money. Now that I manage other people's money I am much more disciplined, organized, and methodical. This has made me much better trader.
Managing other people's money makes you a better trader because you have to be professional, it makes you focus and forces you take your actions seriously. This is not a game. I'm not saying that you should manage other people's money to be a successful trader. I'm saying that you should train yourself to manage your money as a hedge fund manager would, professionally, having a game plan and being responsible to others. This helps you to be less emotional and lets you to make better decisions.
Ok, so how do I manage my money like a hedge fund?
1) Have a performance goal. Have a target, define how much you want to earn. A goal could be for the fund to consistently earn a 20% return each year. The goal needs to be realistic and achievable within your skill set.
2) Have a plan. Answer the question: how are you going to achieve your goal. My fund is going to make its money by selling options and collecting time decay. Specifically, by using a set of income strategies: iron condors, credit spreads, calendar spreads, short puts and butterflies. Each strategy has a defined plan with entry and exit criteria. There is no improvising, you must know exactly what to do given a certain set of parameters.
3) Think in probabilities. Answer the question: is the reward worth the risk I'm taking? Know the probability of success of each trade. Do you have an edge? For example, when setting up an iron condor with a 81% probability of success and a 4:1 risk reward ratio you should know if this trade has a edge or not. In this case, you do have an edge. If 81% of the times you can earn $1 and 19% of the times you can lose $4 you have a $0.05 edge.
4) Have well defined risk parameters. This is your safety valve, your eject button, your parachute. It is what lets you sleep at night. In my hedge fund, I always enter a trade if and only if I know what my worst case scenario is and I am ok with it. I know exactly, when I need to push that eject button to get out of the trade. You must define the maximum loss you can live with in a trade and commit to taking the loss when the trade hits that point. This is allows you to live to trade another day. The risk parameters should not only be for individual trades, you must think on a portfolio basis also. For example, at my hedge fund we do not risk more than 2% of the funds capital on any one trade. Also, as another safety precaution, if the portfolio loses more than 6% in one month, we must first stop the bleeding, then stop trading for a day, and re-asses the current strategies before putting any new trades on.
5) Control your emotions and follow your plan. You should not let your emotions take over your decision making. If you have a good process in place, you will be able to make better decisions and save yourself from losing money. You should have a checklist to review before making a trade. The same way an airplane pilot runs down a check before taking off. Do you have enough fuel, what are the weather conditions, etc. In our lingo, what's the volatility, how is the skew looking, how many days to expiration, what's my max loss, what's my profit target, how much margin is required, etc.
6) Measure your performance. Since a hedge fund has investors, we need to report our performance. As an individual, you must monitor your performance in order to know whether you are achieving your goals or not. This is like the altitude gauge of an airplane; by knowing how high you are you will avoid crashing into a the sea. By knowing your performance you can make adjustments to your strategies in order to achieve your goal. You should know real time your performance in individual trades so you can react and make adjustments. Also, you should know the performance of your portfolio.
7) Always be learning. Constantly strive to become a better trader. Trading is like karate, you never finish learning. Every single day I learn things I didn't know. Have a trade log, learn from your mistakes. Also, constantly read the latest option books, speak to other traders and try out new ideas. Have a trading coach or mentor. I would encourage you to never stop learning. If you could improve you performance by 1% a year, you'll be a very happy (and rich) camper before you retire.
I hope this write up has been useful to you. Wish you a lot of success. Take your money seriously, manage it like a hedge fund, and you will become a better trader.
-- Dennis
Dennis Chen is the Managing Director of Smart Income Partners, Ltd., a hedge fund specializing in option income strategies. Dennis earned his MBA from The Wharton School of Business.
