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.

Posted by Option Addict on 1/25/2007 at 12:31 PM | Permalink