As someone deeply involved in options trading, I recently came across Howard Marks, the co-chairman of Oaktree Capital. His views on risk, laid out in his new video course, were incredibly insightful and made me rethink some aspects of my own strategy. I found many of his points applicable not just to traditional investing but also to options trading. That’s why I’ve decided to write this blog post, summarizing his key ideas with some of my personal takeaways and additional thoughts on how they can apply to trading options.

Risk Isn’t Volatility

Howard Marks emphasizes that risk is not the same as volatility, a key point often misunderstood in both traditional investing and options trading. Instead, he defines risk as the probability of loss. This distinction is crucial in options trading, where the volatility of the underlying asset often influences the pricing of options. While volatility can present opportunities for higher returns, it doesn’t necessarily equate to higher risk unless there’s a genuine potential for loss.

In options trading, particularly when we sell options, this view on risk is vital. Selling options (for example, selling naked calls or puts) may seem like an easy way to earn premiums. However, while short-term volatility might make these positions profitable, the true risk lies in the possibility of significant loss if the market moves against your position. Understanding that risk is about the chance of loss helps guide decisions on when to exit, and when to stay the course.

This is why a key metric that we use in options trading to evaluate this risk is Conditional Value at Risk (CVaR). Unlike basic volatility measures, CVaR gives a more nuanced view of risk by estimating the average loss that could occur beyond a certain confidence level – essentially, it focuses on the worst-case scenarios. This is particularly useful for options sellers, as it accounts for those extreme market events (or tail risks) where a short option position could result in substantial losses.

Risk and Return

Marks challenges the common misconception that taking more risk leads to higher returns. This is particularly important in options trading, where the potential for high returns from strategies like selling naked options or engaging in highly speculative positions can be enticing. While these strategies often come with the allure of high premiums, they also come with the risk of significant losses.

I learned this the hard way when I sold put options on WeWork. The premiums were incredibly juicy due to the high implied volatility, and it seemed like a great opportunity at the time. But when WeWork announced bankruptcy, the trade turned into a full loss. It was a painful reminder of Marks’ key point: just because the potential return looks high doesn’t mean the trade is worth the risk.

As Marks would argue, the underlying risk-return relationship must always be carefully evaluated, with a clear consideration of extreme outcomes. In options trading, it’s critical to assess not just the upside potential but also the risk of black swan events that can lead to significant, unexpected losses.

Asymmetry – The Hallmark of Superior Investing

One of the most valuable takeaways from Marks is his emphasis on asymmetry – achieving higher gains during good times while minimizing losses during bad times. This idea is especially relevant in options trading, where smart traders aim for a favorable risk-reward balance. Take the concept of selling credit spreads instead of naked options. By limiting the downside risk (through buying a further-out option), you sacrifice some potential profit but protect yourself from massive losses if the market moves dramatically against your position.

If you sell a put credit spread on a stock you believe won’t drop significantly, you create an asymmetric opportunity: if the stock stays above a certain price, you profit from the premium; if it falls, your loss is capped because of the protective long put. This is a prime example of Marks’ concept of aiming for smaller losses during bad times while still benefiting from upside gains.

The Hidden Nature of Risk

One of Marks’ most interesting observations is that risk is often hidden and deceptive. Just because an investment appears to be performing well doesn’t mean it’s not risky. In options trading, this often manifests in trades that seem safe because they haven’t caused any losses yet but have significant hidden risks.

Take selling far out-of-the-money options, for example. This strategy often generates consistent, small premiums, leading traders to think it’s relatively safe. However, the hidden risk lies in the possibility of a sharp market move that wipes out all those small gains in a single event. As Marks puts it, risk doesn’t reveal itself until tested, and in the case of selling options, one big tail event could expose the significant downside. An example of this is our 1-1-2 strategy during volmageddon in August 2024.

The Importance of Risk Management

Risk should be managed continuously, not sporadically. This is especially true in options trading, where markets can shift quickly. As an options trader, you need to constantly reassess your positions, adjust your risk exposure, and remain vigilant. Markets don’t stop to let you adjust, and neither should your risk management.

A common way to manage risk in options is through position sizing. If you’re trading with a small account, risking too much on any single trade can lead to devastating losses. By allocating a small percentage of your portfolio to each trade, you reduce the chances of being wiped out by an unexpected market movement.

Another crucial aspect of risk management is avoiding the temptation to chase high returns. In options trading, it’s easy to get drawn into high-risk strategies for the allure of large payouts, especially when you’re on a winning streak. However, just because a trade offers high potential returns doesn’t mean it’s worth the risk.

Application of Marks’ Insights into Options Trading

One particularly powerful idea from Marks is his advice on how to handle losses. He emphasizes that one of the worst mistakes an investor can make is being forced out at the bottom, missing out on the recovery. As option sellers, this is especially relevant when markets move irrationally against our positions. Instead of panicking and closing a short position prematurely, it’s crucial to have a plan in place to manage the trade effectively. I highly recommend checking out Tom Sosnoff’s tips on defending against irrational market moves. His expert advice, including strategies like rolling your options or adjusting your position, is a great complement to Marks’ broader principles on managing risk.

Another useful takeaway is the understanding that some assets can appear riskier simply due to their price. In options trading, expensive premiums for highly volatile stocks may seem appealing, but they also represent high-risk scenarios. On the other hand, cheaper options might present better opportunities for safer trades. It’s important to evaluate not just the trade’s potential return, but whether the premium truly compensates for the risk involved.

Embrace Asymmetry and Manage Risk Wisely

Howard Marks’ insights on risk challenge conventional thinking and provide a powerful framework for options traders. His focus on risk as the potential for loss– not just volatility – offers a clearer perspective on selling options, where the real danger lies in unexpected black swan events. Metrics like CVaR refine this approach by highlighting these risks, giving you a stronger grasp of potential losses.

Ultimately, success in options trading isn’t just about maximizing gains; it’s about protecting yourself from ruin. By applying Marks’ principles, particularly his emphasis on asymmetry – achieving gains while minimizing losses – you can navigate markets with both confidence and caution. If you want to excel in options, mastering risk is non-negotiable.