Risk Management - The Key to Consistent Profits

Yesterday's dramatic surge in the 10-Year Note market resulted in prices moving to extreme price levels. Watching futures prices plummet yesterday made me think just one thing 'this is pure panic!'

Unfortunately, we can't always be right in our recommendations. Sometimes we get caught being on the wrong end of such a move. If we are unprepared, often we find ourselves instinctively "bailing out." We are motivated by the fear, by the panic. We let emotions take over and this results in prices moving beyond the +2 or -2 levels. These levels illustrate not reality, but pure emotion. Short covering spikes are pure emotion, panic selloffs are pure emotion. They do not reflect reality. Once the dust settles, prices revert to the mean. It happens all the time.

Having Adequate Capital

Never go into a trade without knowing the risks you might face. You must understand what the current level of volatility is, what the average level has been and how high volatility has been in recent time frames. If volatility is currently low but rising, as has been the case for bond prices, then you have to believe that dramatic moves, pumping up volatility, might be in the cards.

You cannot ignore the trends when volatility is rising. I've been in the bond market for a long time and have learned never to fight the trend. I remember back in 2004/2005 when I was certain rates would rise, the only time the market went my way was in overnight trading. During the day, rates trended lower and lower and the people on tv encouraged the wonderful news - how lower rates were wonderful for the economy so that we could refinance our mortgages and pump up the economy.

Now I am readding far too many bond analysts looking for the expected pop in bond prices. And while it might happen and they might be right, they are fighting the trend. This is something that must be avoided if you want to consistently make money.

Having adequate capitalization is the biggest key in futures trading. Markets go up and markets go down. Sometimes we are right and sometimes we are wrong. But if we can go into a trade having a plan, knowing when to admit we are wrong, and exiting the trade with a small loss, we will live to trade another day. When selling options out of the money, as some of us do, solid capitalization is the key. We sell options at prices at the extremes. Rarely do prices move to these extremes but sometimes they do. That is part of the game. While there might only be a 1% chance that it will happen, considering that there might be 200 trading days in a year, rather than being unprepared for it, you must plan for it happening and must have sufficient capital on hand to avoid having to close out your position at the absolute worst time. When the dust settles, prices revert to the mean. They always do. Option premiums deflate, they always do. If you are inexperienced or your broker is inexperienced, you will find yourself getting out of a great position at the absolute worst time.

Selling Premium is the Best

If you've read my Time is Money articles which you can access through the links in the right hand column, you'll understand why I believe that selling options is the best way to make money consistently, month after month. But don't think that you can go into a bond position with $5,000 and make a ton of money. The markets are handled by "strong hand" pros who can whip markets around at will, devasting the little guy. If you are a little guy, you can still partake in this game plan but you need to limit your risk.

If you can't put up at least an extra $10,000 or more above the initial margin requirement, establish a credit spread. A credit spread allows you to receive income but limits your loss in the event you are wrong. You won't make as much as by just simply selling an out of the money option, but you will never lay awake at night wondering when the price move will end.

If Your Broker Exhibits Weakness

It is times like this when we can truly see the experience of our broker. Is he nervous? Is he telling you that you should now take additional measures that may in fact increase your risk? If you are in the bond market now and on the wrong side, you should be able to really judge the knowledge and experience of your broker. If you are undercapitalized and sweating it because your broker overleveraged you, then you need to change brokers. If you are well capitalized and understand what you are doing, extreme times like this should be a thrilling time to be able to watch the awesome power of markets. If you are worried because your are undercapitalized or worse, your broker doesn't know what to do, contact me. While I am not a broker, I can provide you with good advice and help you find a good broker who can meet your needs.