How is trend following with a stop loss optionality similar to a call option?
In What is Trend Following?, I said;
Trend following is a directional trading strategy that uses price-based "technical" indicators to identify trends with the objective to gain exposure to the direction of the price trend, expecting the trend to continue.
We can get directional exposure to a trend unless we pull the trigger.
I developed the skill to pull the trigger by predefining my loss if the position doesn't keep trending, and let it rip.
I shared the concept in How To Manage Risk So You Can 'Let It Rip' with Investor's Business Daily last summer.
The most common question from it is what I mean by predefining my risk of loss.
A key part of asymmetric trading systems for asymmetric risk/reward and asymmetric investment returns requires that we limit the downside, and let the profits run.
As I intensely studied the mathematical expectation of trading systems, I concluded the downside drawdown is the part I have the potential to control.
If a position is trending down, I can sell to exit, and reduce my exposure to zero.
I could also use exchange traded options for defined risk.
ie. if I buy a call option for $5 that's all I can lose if the position doesn't become profitable.
It's a sure thing I'd lose the option premium paid if I don't exit above the breakeven, but it's also a defined loss that wouldn't be larger.
I could instead place a stop loss exit $5 below the entry price for a similar effect, but the position could gap down $10, and the loss would be larger than the limited call option would have been.
With a stop loss, there is no guarantee it'll limit the loss, even with a stop limit, the outcome is uncertain.
These are the kind of portfolio management decisions we get to choose as investment managers.
Below I've taken the two different choices and lined them up for comparison.
The thing to keep in mind is options are bought with a premium paid to have the right to buy (or sell) a stock or other market in the future.
Options are renting, not buying, and the premium is driven by several factors like volatility.
It's not as simple as this idealized example to choose an option over taking a position in the underlying.
But options can give us options, and in the case of this writing, they provide us with a simple educational framework to grasp the most basic parts of active risk management required for asymmetric investment returns.
Indeed, asymmetry is all about limited downside, and unlimited upside, or at least an upside that's greater than the downside.
I hope this helps!
For more information about options, read a copy of the Characteristics and Risks of Standardized Options, also known as the options disclosure document (ODD). It explains the characteristics and risks of exchange traded options.
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