Last updated on February 14th, 2020
Do you understand your risk on every option position that you put on
Are you comfortable with the worst possible outcome if the absolute worst scenario happens?
These are important questions to ask yourself on a regular basis.
In our Options Fast Track training room we talk about maximum risk on every trade to make sure traders are very clear about that could happen if the worst case scenario does play out.
Unfortunately as I was looking at my Twitter feed earlier in the week, I stumbled across a story that covered an awful mistake made by an Arizona stock trader who didn’t ask himself the above questions about understanding risk and is now paying for that mistake in a big way.
Let me give you the quick version of the story.
The Arizona trader shorted KaloBios Pharmaceuticals (Symbol: KBIO), which is a $2.00 stock looking for a quick scalp to the downside.
After putting on the trade, he stepped away for a few hours to attend a meeting and when he came back he noticed KBIO stock was trading up over 500% to $12.56 per share. The problem here was that Mr. Campbell’s position had unlimited risk if the stock moved higher.
Immediately his position was down over $144,000!
He was trading a $35,000 account with Etrade at the time. Taking a look at the screenshot below you can see he was facing a margin call or over $106,000.
He now owes Etrade more than $106,000 with no way to pay it. He has started a GoFundMe campaign to try and raise the funds to repay the full amount.
Now we could talk about this one in detail for hours. However, I think there are some very important take aways from this whole situation that every trade should be aware of.
Let’s outline them below:
Understand your maximum risk before ever placing a trade.
I don’t know if Mr. Campbell knew his risk before placing the trade or not. However, when shorting a stock it’s crucial to understand that you have unlimited risk.
Sure, you make money if the stock moves lower but you also have unlimited risk if the stock moves higher.
A stock can only go to zero, so his KBIO short stock position only had $2 profit potential per share. We also know a stock can move as high as it wants which left him with the unlimited risk.
He assumed his broker would take him out on such a big move before his account was wiped out and then some.
The argument could be made the Etrade should have done more to help him out, but in reality it’s up to us as traders to understand our maximum risk on each trade and put a plan in place to deal with that scenario when it comes up.
Many new traders look to short cheap stocks because they can do so with a small account size. As you can see with this example it does not pay off to do so in the long run. There are much better products to use in place of shorting stock to try and play the downside.
Using stock options is great alternative that will allow you avoid the big risk that shorting stock brings.
Trade with defined risk trade types.
If you have read my Options trading articles over the past few months you know that I love trading options. There are many reasons for this and near the top of that list is the ability to use defined risk trades.
In the case of Mr. Campbell’s short KBIO stock position he wanted to play the downside. Unfortunately, he placed a trade that only had $2 of profit potential with the unlimited risk like we talked about earlier.
Instead of shorting stock to play the downside, I would much prefer to use a strategy like a long put or a short call spread.
These options trades would still provide great profit potential if our stock moves lower but they also come with limited risk. We know what our worst case scenario would be before we ever get into the trade.
In the case of a long put, we can never lose more than what we pay for it. In the case of KBIO it didn’t offer options as it was only a $2 stock. So in my case if I can’t take a defined risk position and know my risk up front then I don’t trade that product.
Simple as that.
Don’t mistake using a stop loss as defining your risk.
Many traders use stop loss orders as a false sense of security. They think these orders will define their risk and leave them with a small loss if the position moves against them.
What they don’t realize is that there are situations where the stop loss does you no good.
For example, what if a stock makes a gap lower at the open the day after you put a position on? If that gap causes the stock to open past your stop, then you will take a larger loss than you anticipated.
Also, if you aren’t trading a liquid stock then your stop order could be filled at a worse price than you anticipated. By the time Etrade was able to close Mr. Campbell’s KBIO short position the stock was already trading another $2 higher than when it was when the loss was first noticed.
Define Your Risk Before Trading
As a trader, it’s much better off using a product that allows you to define your risk before ever putting on the trade.
Trading involves risk regardless of the product you are trading. Markets have an uncanny way of making people pay a big price when mistakes are made.
I think we can all use this story as a reminder to understand the products, and the risks associated with those products, before we ever put our hard earned money on the line.
I’m sure Mr. Campbell thought his trade had the potential for a quick profit to the downside.
The problems all started when he didn’t realize that shorting shares of stock also comes with the unlimited risk.
Unlimited risk meant taking losses larger than his account size. Now he is facing a negative balance of over $106,000 as a result of now knowing the risk associated with his products.
Trading can lead to very nice returns in a quick time frame which is why we are all attracted to the markets.
Like any other business, you have to have a plan in place for every situation.
Don’t make the mistake of using products or trades that you don’t understand.
If you use the tools and trade types that are available in today’s markets you can be an active trader using very safe trades. Trading options is a great way to be active in bullish and bearish markets with defined risk trades.
Learn from Mr. Campbell’s mistakes and focus on defined risk trades so this story is not repeated down the road.