Example of Maximizing Probabilities and Managing Risk
Let’s use this chart on the VIX to illustrate the combination of probability recognition and risk management in some actual trades. The chart shows an obvious pattern of increased volatility followed by a return to normal volatility. Every time the volatility increases, we are provided opportunities to enter positions that should prove profitable as things return to normal. Each one of these spikes was caused by some sort of trigger, and we’ll focus on the October 2013 shutdown of the US government over the budget battles in congress for our example.
Our probability analysis told us that this October volatility event should be short term with a quick return to reduced volatility. However, since it is difficult to know exactly how high or how long the volatility may last, we managed our risk by dollar cost averaging into our positions and by splitting the investment over different time frames.
In this case, we used a volatility-based ETF and purchased December 2013 option spreads for $2.45 per contract and January 2014 option spreads for $2.50 per contract.
The December spreads were sold in mid-November for $4.60 (88% return) and the January spreads were sold in mid-January for $4.95 (98% return).
Obviously this trade worked out exactly as predicted, but if it hadn’t, we only committed a portion of the fund to this particular event. And, we managed our risk by averaging into the position and spreading the investment over different time periods to maximize our probability of success.