Welcome back. Did you throw on a few back ratios? Did you get a feel for clicking the buttons? Did you also realize the difference in risk between the two different incantations of this trade? I realize its only been a week and so there is probably not much movement on any trades you may have put on but there is still value in practicing the orders to fix any click errors and to get familiar with the risk graph.

Now that we understand the mechanics of placing a trade like this we can now explore what to do with the trade if it goes our way or against us. We have certain metrics that we have to be aware of when doing a trade like this. We have overall risk to deal with in addition to time concerns as well. These trades must be handled in a certain manner to prevent max losses.

First, we need to discuss the risk in this trade as it pertains to our overall risk to our portfolio. For example, let’s say we have a 100K portfolio and we as smart traders are only willing to risk 1% of our portfolio on any one trade. This is a smart approach and keeps the risk of ruin at bay. For those not familiar with the risk of ruin essentially it goes like this…the higher percentage a trader risks over all the more likely he or she is likely to blow up their account. There is a visual below to help drive this concept home.

You can see from the above chart that the more of your total bankroll that is risked the more likely you’re will get into the blow-up zone as evidenced by the mushroom cloud in the upper left corner. The upper left corner is showing a risk of over 85% of the total bankroll, this is known as trading suicide. We bring this point up because it is paramount that use proper position sizing in using these back ratio types of trades. We have to take the worst case scenario and plan for it. In the case of a back ratio spread, we must assume that the stock will pin at the long strike and plan accordingly. So, in the case of the IWM trade from last week, the most damage we could do would be approximately $435. So, if we are risking a total of $1000 on any one trade then we can do 2 contracts, this would bring our total risk to approximately $870 in the worst case scenario. See the chart below for the explanation.

Now that we understand how much pain we can endure if this trade goes against us we can start to make some moves if things aren’t going our way. You will notice that our worst-case scenario only comes if the price pins at our long strike price on expiration. This would mean we would let this trade run until expiration without doing anything. This is not who we are! We would never let this run to expiration without trying to change our fortunes. So what can we do? Well, there is a very good practice that is used when dealing with longer-term directional plays and that is a re-evaluation of the trade at certain intervals. For example, if you have a long call trade on for four months and you have a certain bias or expectation of what the equity should do but then it doesn’t move in the first two months then a re-evaluation of the trade is in order. One needs to see if the original premise still holds true and if so then closing the original trade and opening a new one with the four months to expiration is just smart business. That is what we would want to do with a back ratio as well, if we believe the equity is still going to move and we are half way to expiration and it hasnt moved then we need to get in there and redo the trade.

We have taken care of the time aspect by not allowing it to hurt us much. We control Theta by making sure we are far enough out that it is a non-factor. Next, we have to look at what to do if the trade goes against us from a directional standpoint. In the case of the credit trade we can let the trade go way against us and there is no additional risk and we will even walk away with a little scratch in our pockets, just slightly more than commission but it sure beats giving cash away. The key to managing this trade is to watch the prices closely. This is where it is best to slap on some alerts at certain price levels to remind us that this trade deserves our attention. The only other issue we have to look at is when to take profits. This harkens us back to our technical analysis. We need to look for logical resistance levels that would slow or stop the progress of the advancing equity or we can decide to get out at pre-determined gain percentages like 50% gain or 70% gain. In my humble opinion the first exit type is best, let the market tell you when to get out by showing us places of resistance that have gone before.

Now you know how to manuver through the wonderful world of back ratio spreads so get out there and give them a shot in your paper trading accounts.

In next weeks blog we will go through the steps and put on a mock trade and then follow it along to get some real perspective on this awesome trade!!

Trade Well All!

Coach Holmes