Traders manage risk using a multitude of strategies, from order types and technical analysis, to stops, trail stops, OCO (one cancels other), bracket orders, triple tops, and double bottoms. However, with the VIX hovering north of 60% over the past two months, what has been effective risk management in this period of hyper-volatility?

First, it is imperative to understand that volatility (as measured via the VIX) is approximately three times its 20-year average. Yes, three times! The Vol is intimidating to even the most hardened traders, but more importantly, have you adjusted your risk management strategies to accommodate this unpredictability? What has been consistently overlooked by most traders is that with volatility three times the norm, you should have then cut capital allocations by 1/3. Furthermore, volatility has systematically ripped through stops, decimated technical levels, and gapped well and beyond any foreseeable trail stop or stop limit. In this period of intense volatility, risk management becomes more about strategies deployed and less about being right or wrong directionally.

I have always made the argument that at some point during the life of a trade it is both a winner and a loser. The key aspect is holding the position even throughout the most adverse market conditions in order to weather the volatility storm while remaining defined risk. Enter the defined risk vertical spread. The vertical spread allows the implementation of a defined-risk environment, and more importantly allows the position to mature without being stopped out. Here is a simple example of the benefits of a vertical spread in which we will risk $1.00 to make $1.00. Although this trade has no statistical advantage, it does provide a maximum sustainable risk of $1.00 and allows a directionally biased trader to hold even a losing position during extreme volatility. Any stock or single option trades in conjunction with variable order types would have been stopped out, yet the vertical spreads sustain the risk and keep the trader completely intact and in the position.

In future posts, we will dig deeply into the structure and deployment of defined-risk vertical spreads. In the meantime, keep your risk defined and your delta controlled!

thinkorswim, Inc. and its registered employee, Don Kaufman, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.