Planning Your Bet Size

Plenty of questions have been passed around recently about position sizing and money management. If you ever hear me use the words "play defensively" this is what I am referring to. Properly sizing your bets and how you manage your money is the key ingredient to being a successful trader. Allow me to elaborate.

Successful trading is not always winning or losing. It is how you distribute your capital, withstand emotional decision making (psychology), and staying disciplined to your rules and financial goals. Money management is a defensive concept and keeps you alive to trade another day. Lets go over a few of the specifics in order to effectively plan your betting (position) size. Keep in mind if your ideas here are to be told exactly what YOU should do, close this window now. As usual, I try to promote original thought, and the reasons behind concepts, but since you and I are different people, what works well for one of us, might not be in the best interest of another (disclaimer).

Risk

Risk is the likelihood of a loss. At the moment we take a trade we are at risk of a loss. Positions are constantly fluctuating in value and there are many variables that influence risk. In order to account for this risk you have to consider these variables. Assuming we are talking about options... stock conditions, news, fundamental conditions, volatility, and time. Having done this research you need to quantify a likely risk (how much the stock could move) and a comfortable level of risk (what you are comfortable losing on this trade). Not just with the individual trade but as a portfolio as well (stop & bet size).

Keep Losses Small

Hate hearing that yet? Here is how you do this: To generalize the concept and use round numbers, assume I have a one dollar account :) I don't want to blow up my account anytime soon, so I need to spread out my capital. Most traders claim to use 1, 2, or 3% at risk on any one trade. Here is how I like to do it. I like to fluctuate. Some times when I am hot I fluct up, and when I cool off, I fluct down. In this trend I have been steady at 2-3%. Why? I have been winning more than losing and I want to optimize this. Back in July-August when I had my worst losing streak ever, I was trading at 1/2 - 1 % per trade. Apply this to your account immediately, or at least scale back how much you bet. It will keep you in the game longer, and keep the losses in line.

Become a risk manager

To manage risk is to control and direct the probability of a loss. Whether this is through taking offsetting positions (hedging), portfolio weighting, or adding/subtracting into a position, be thorough when considering your possibilities. As options traders, many don't realize the opportunities we constantly miss out on. Such as selling premium against existing trades when things cool down (but don't move against us). I have heard many comment on the way ThinkorSwim (not a recommendation or endorsement to trade with them) let's you position your account to see aggregate delta, theta, gamma, and vega positions across the board to better manage risk. A very nice tool I must say.

Diversify

Many don't realize that if you take trades that are too correlated to one another, it is just like doubling down on a position. If you see more than one trade in a group that is setting up nicely, trade the ETF. Diversification is not a negative it is a positive, and an essential puzzle piece to keeping a healthy portfolio.

Calculate Trade Risk

Now you have decided the amount to allocate to a position (1-3%) how many shares/contracts should one buy? I'm looking at this option that costs $1.00 per share, and I have $1000 to spend. Should I buy 10 contract and risk all $1000?

Not necessarily.

As you analyze the trade, what if it is right at support. Meaning a close below this would tell you that you were wrong and to exit? You wouldn't need to risk the whole premium...but you'd probably be able to risk half with a little wiggle room left. Your analysis concludes that 50% of that premium is what you want to risk. At $50 a contract you could purchase 20 contracts now, and still not have more than $1000 at risk. Even though there are more contracts involved, the risk amount doesn't change. Now that you've optimized your bet size, you stand to make a better profit since there are more contracts involved!

If the option at expiration was now worth $2, had you purchased the 10 contracts, you would have made a $1000. Had you optimized your bet and traded 20, you would have made $2000, without a penny more than $1000 at risk.

Hope these points helped. Now I am tired. After a nap I will try to come back with something else to throw at you.

Excellent comments! I appreciate your thoughts on "keeping losses small" and "optimizing profits".
Thanks for everything you do.

I hope the nap was refreshing!

Amy

Jeff, you are way to good to us with your insights and time. I hope we can give back a fraction of what you give us so freely.
Thanks
Brent

Thanks for all of the wisdom. The timing on your posts are many times right on with how things are going for me. Keep up the good work.

Danny K

For you fellow geeks out there, here is the position sizing formula:

Position Size = (X*C)/(P-S) rounded down, where
X = your protfolio size
C = the amt of risk (e.g., 1%)
P = entry price
S = stop

Example: You have a $20K portfolio, you risk 1% per trade, your entry is at $100, your stop is at $98.

Position Size = 100 shares, voila!

It can easily be adapted to option contracts, also.

The rounding down is for conservative geeks like me. If you're like Jeff, round up:-)

Am I the only one who things that the last 4 weeks on AAPL's daily candle chart looks like an owl? Perhaps a sign that this was a 'wise' trade? hmmm...

Also, Loving the RIMM action today, though the minute I type this i'm sure it will zoom back up and eliminate the lower high just formed.

Keep an eye today on BOL.....possible breakout??

Bob R.

Thank you Jeff and all in the group,

I know Jeff you buy OTM option when it is a break out of a price pattern. Do you do the same thing when it is a bounce from support or resistance? Do you always buy OTM options?

I still will like from you if you don't mind how is that you get to buy more contracts. Is it because is OTM option what you are buying and because the price is lowe you are able to buy more contracts?

I am not in the Master Talk, so I only get to find the stocks you discuss at this site. Maybe some of you could answer my questions.

Thank you
Alessandra

Alessandra,

Jeff has answered this question a few times. So, I'll help him out...

Support bounces = ITM
- (more expensive/less contracts/higher probability trade)

Pattern Breakouts = OTM
- (less expensive/more contracts/lower probability trade)

FYI: Since support bounces are normally played for a couple of points, it makes more sense to go in the money. However, with a nice pattern setup, with a large target price, it makes going out of the money more attractive.

Hope this helps.

Larry

Lastly,

Is anyone watching the DOW intraday?

Take a look at a 60 day chart (then 20 day to zero in). It looks to me like a bearish rising wedge. Now testing support around 12,450. I kinda expected a little bit of a dead cat bounce mid day to re-test the breakdown (up to around 12,500-12,525), but not many buyers coming in for a friday afternoon (maybe monday am?). If this level gives away at 12,450, major support at 12,350 (another 100 points to the downside).

Looking at the markets intraday 'could' help with entries and exits in the choppy market.

Larry

BTW: Rising yeilds could be bearish for homebuilders, financials, reits, and utilities.

John V,

Awesome formula, this is very helpful for those building spread sheets.

Larry, THANKS! It is so nice to see others lending a helping hand in the comments. I owe you one.

Alessandra, hopefully Larrys comments helped.

Thanks!

Jeff

Thanks Larry,

That sure helps.

Thank you Jeff, you have a great group of students, that means you are amazing teacher. I like to continue learning from you and from your group too.

Thanks to all,
Alessandra

Thinking about shorting ODP

Any thoughts?

I have been looking at ODP today as well. My concern is that the volume is just below avg. so far today so I am not convinced that there is a lot of conviction in this move. I am planning to not get in today unless volume increases significantly and I am convinced it will close below support.

Sean M.

THATS ONE LONG NAP, RUMPLESTILSKIN

Sean,

Looks like support is holding thus far. Monday may be a make or break for the chart. Daily MACD Positive Divergence, intraday looks bullish, sitting at support. I might look to get some strengh out of the stock in the first part of the week (or so)before going short. Todays entry would only yeild a R/R of 2:1 from what I see (35 might be all you see by earnings).

You might get a little better R/R by playing the 3 month downtrend line. Then if it finally breaks support, it would be an added bonus.

If you trade intraday, look for some strengh up to 38-38.25 for a possible entry.

This analysis might go by the wasteside if it trades lower on monday.....

Larry

p.s. No problem JK & A, glad to help out a little bit

Larry,

I agree. Thanks for the input. There were a number of opportunities that were interesting today that were not validated by volume such as FDS. Monday should be interesting.

Sean

Successful backtest around 12,525 now in (see friday's intraday comment).

I know this is going 'cross' trend, but I'm going out on a limb and projecting the next two stops for the Dow.

< OK, call me crazy.....>

Short Term Target 1 = 12,450
Short Term Target 2 = 12,350

Sean, ODP bouncing today (good hold). Keep watching if you want a better entry...

Larry

As Mike Coval would say...

"news changes everything"

With the GDP and Fed, bullish price action has nillified the short term pattern.

Larry

Post a Comment
...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT... ...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...I'M AN OPTION ADDICT...

About me

  • I'm Option Addict
  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
My profile

Prescriptions Here!

Other stuff

Blogarama - 
The Blog Directory
Directory of 
Finance/Business Blogs Finance 
blogs Top Blogs Finance Blogs - BlogCatalog Blog Directory