Understanding Relative Risk with Options Trading

The goal of this entry is not to cover all possible scenarios when it comes to trading, or even options trading for that matter. It is more designed to cover how we view risk as it pertains to our strategies and methodologies. It is also important in evaluating performance. Instead of the typical banal mindset of 'what was the return?', the real question should always be 'what was the return on risk taken?'.

Also, it may give a better insight into how we quantify weekly risk for our strategies.

A few items covered that may or may not be conventional in the trading world, but we will clarify. For this, we will use examples from this past week of trading in the Pure Alpha Strategy.

• Risk Budget

• Absolute Risk

• Directional Risk

• Relative Risk

Risk Budget

This is the total amount of risk capital one is willing to commit to execute a strategy and ideally reach their target profit goal for a specified period, generally on an annual basis. For Pure Alpha we define this metric as $25,000 per 1x scale. So for a client who wants to trade 4x scale, this amount would be $100,000 if they choose to follow the strategy baseline risk parameters.

A Risk Budget can change over time and can be fluid, but is basically the initial and possibly ongoing amount to execute a strategy through ups and downs.

Technically, and assuming a constant Risk Budget, if one is initially profitable and never breaches the amount of their initial, or even an adjusted Risk Budget, drawdowns become less relevant if the losses are on gains already captured only. At the minimum recommitting to a Risk Budget each year, or even at the start of a new quarter, might give one better perspective to 'stay the course' in down periods.

Absolute/True Risk

This is basically 'Black Swan' type events that are completely unexpected and generally results in a total loss of all capital exposure to a given investment, allocation or series of allocations.

An example of this would be a 9/11 or Black Monday type event. Our total capital exposure this week for Pure Alpha (the max total premiums of the positions we had on at once) was about 5.2k at 1x Scale, all for expiration this week. This is about 20% of the $25,000 Risk Budget (per 1x scale). Let's assume that something happened that caused the market to close unexpectedly and remain closed for the rest of the week. Then all brokers told all clients to pound sand and that any options they had that expire this week will expire worthless, as the market will not reopen before they expire. This is an example of Absolute Risk.

Another example, albeit also extreme, is if all the options on both Core and Hedge positions the underlying literally made zero positive movement in favor of the options and we did not close any partial positions and held all positions to expire with a value of zero. Due to our risk management protocols I do not foresee any scenario where ALL the positions we have on at once would expire worthless. However, it is a good metric to understand.

While extreme, and might be uncomfortable for this to happen, it should be accepted as possible.

Absolute Risk = Total Premium Spent or Total Premium Exposure at any given point.

Directional Risk

Similar to Absolute Risk this is fairly simple, at least for our purposes. Directional Risk is simply the difference between the call and put premiums or exposure. If we had $2,000 worth of calls purchased and $1,000 worth of puts, our Directional Risk would be $1,000. Now of course some of the same factors for Relative Risk (below) come into play, but since there is, at least initially when each trade is taken, a directional bias with the trades, this is a simple and effective way of evaluating a key risk element.

Directional Risk = The higher number of call or put premium - the lower number of call or put premium.

This week our max directional risk was $769 per 1x. With a max call premium of $3,029 and a max put premium of $2,260.

Relative Risk

Relative Risk is in play each week. Since the way we structure our trades generally involves some element of hedging, Relative Risk is highly dependent several factors that include:

• Time before expiration

• Proximity of underlying Stock or ETF to being in-the-money

• Position sizing, both Core and Hedge

• Hedge ratio relative to Core Positions

• Profit taking and stop levels, both partial and total

  
  

While it is significantly more nuanced than this, the MAXIMUM Relative Risk for Pure Alpha on a Weekly Basis is generally between 65-75% of the Absolute Risk. So, for example this last week with an Absolute Risk of 5.3k, the Relative Risk was around 3.7k per 1x Scale if using 70% of the Absolute Risk.

Relative Risk = 65-75% of Absolute Risk

Conclusion

We publish and track weekly and overall return versus the total Risk Budget, as this tends to smooth things out over time and give one a broad, yet gives a clear picture of performance of the capital committed. With that, and to summarize, this is how this past week of modest returns correlates to each of these in terms of return vs. risk, all at 1x scale or a $25,000 Risk Budget.