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How Position Sizing Impacts Your Returns


How many times did you hear from traders "I make 50% on most trades, so I can live with few 100% losers"? I guess too many. What those traders don't tell you is what impact those 100% losers have on your overall portfolio. This article discusses why position sizing is key to good and sound risk management. 

Lets take a closer look at position sizing and why it is critical for your financial health.

 

How much should one allocate to any given trade?

 

The 2% – 6% rules have been introduced in Dr. Alexander Elder's book "Come Into My Trading Room".

 

The 2% rule is to protect traders from any single terrible loss that can damage their accounts. With this rule traders risk only 2% of their capital on any single trades. This is for limiting loss to a small fraction of accounts.

 

Besides a disastrous loss, a series of losses can also damage traders' account. The 6% rule is lent to handle this. Traders have to set the maximum of accumulated loss for a month. When they reach that level of loss, they have to stop opening any new position for rest of the month.

 

These 2 rules are designed to protect traders from the two types of losses. For those who are able to accept the higher risk, they might adjust the 2% – 6% rules to 5% – 10%, where the 5% is used to protect the account from any single disastrous loss while the 10% rules is used to protect traders from any series of losses in each month.

 

With our earnings straddles, if you limit your holding period to 3-6 days and don't hold through earnings, it is very unlikely to lose more than 20% in a single trade. In fact, most of our losers are in the 5-7% range.

 

If you adapt the 2%-6% rule, then you can allocate 10% per trade, knowing that you don't risk more than 2% of your account. You can adjust it after each trade, monthly, quarterly, etc. It depends on your risk tolerance. Adjusting monthly seems like a good compromise.

 

Of course theoretically, any options trade can lose 100%, but for some strategies, it is very unlikely. You should usually account for a "reasonable" scenario when considering your position sizing.

 

The general idea is knowing in advance how much you risk on any given trade and allocate the capital accordingly. If it is absolutely critical for you not to lose more than 2% per trade, you can set a stop loss of 20% per trade. I personally don't do it for two reasons. First, many times you have couple of days of theta with flat IV and then IV jumps, reversing the loss. Second, with spreads, your fills are going to be terrible if you place stop loss order, much worse than you could get with limit orders. And third, like I mentioned, the loss is very unlikely to be more than 20% anyway.

 

How many contracts should you trade?

 

Position Sizing - The Most Important Trading Rule article has a good explanation of the concept.

 

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I’m not sure about you. But I’m tempted to borrow as much money as I can from my family, extended family, friends, friends of friends, and my banker. Not to mention selling off my retirement portfolio and using the highest leverage my broker offers. I’m tempted to enter the market with as many contracts as I can.

 

Yet, this is a temptation that I MUST resist.

 

This is because there is a 1% chance of losing everything. If this loss occurs, it is one that I can never recover from. Not only will my broker and banker be after me, I will find creditors instead of friends. It is a catastrophic loss.

 

Here is another way to look at it. Lets say you have a trade which you keep through earnings and require the stock to move about 5% to realize the maximum profit. If it happened, you would realize a 40-45% gain, depending on your entry price. The trade would be profitable 8 out of 10 last cycles. However, when the stock moves less than expected and doesn't reach the long strike, the trade is a 100% loser.

 

In comparison, you can have trades which are sold before earnings, producing an average gain of 8-12%, with very limited risk. It is very rare for those trades to lose more than 7-10%.

 

What is better – to make 8 times 40% and to lose 2 times 100% or to make 10 times 10%?

 

In the first case, your accumulative return is 120% (12% per trade). In the second case, it is “only” 100% (assuming 10% per trade). But here is the catch: those returns don’t account for position sizing. Let’s assume you want to risk 2% of your portfolio per trade. In the first case, you know that you will win most of the time, but when you lose, you can lose 100%. So you can allocate maximum of 2% of your account per trade, which gives you a total portfolio return of 24%. In the second trade, you can rarely lose more than 7-10%. The maximum loss I had with those trades was around 20%. So you can easily allocate 10% per trade, which gives you a total portfolio return of 100%.

 

Now you see the difference? With the second trade, I can have much smaller average returns, but with proper allocation, I’m still way ahead.

 

Despite all your efforts, you will eventually have a streak of 4-6 losers. Those who tell you they haven't, are either lying or haven't been in the game long enough. Always ask yourself: How will your account look after 5 straight losers?

 

As a general guideline, I always recommend starting small. Allocate maybe 5-7% per trade and then increase it gradually. Always keep some cash reserve (I recommend at least 20-30%). As for total account size - do it gradually as well. Prove yourself that you can make money with 10k. Do it for 2-3 months. Then increase to 20k. Don't increase from 10k to 100k. The markets will be there long time after all of us are gone.

 

Dr. Van Tharp has some very good articles about position sizing. I would highly recommend his books to learn more on the subject.

 

 

How we use position sizing in our model portfolio

 

In our model portfolio, we allocate 10% per trade. Since most of our trades risk around 25-30% (there are some exceptions), we basically risk up to 3% of our portfolio in each trade. In some strategies (like trades that we hold through earnings) we allocate half position, or 5% of the portfolio per trade. Those are higher risk trades that can potentially lose 50-80%.

 

 

"Profits come in bunches. The trick when going sideways between home runs is not to lose too much in between." - Michael Covel

 

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Posted

Consistancy in sizing has always been a challenge for me. Overcoming the need to win on every trade and taking on too much risk has also been a challenge by overtrading..too many adjustments, doubling down, believing I know things I do not know.

 

I like the idea of establishing an amount you are willing to loose in a month and when that is reached SOH and paper trade until the end of what you consider your month. Either calendar or mid month expiry.

 

I have fight wanting to get even.  Personally now when I feel like I must get back even for the month is when I take a walk then come back and look at where we are.

 

Good comments.  Thanks for sharing

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Trying to get back to even is one of the worst things that can happen to a trader. You allocate 10% to a trade, lose couple trades and then start trading larger size to compensate for the losses. The safest path to disaster.

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I wish I truly understood the importance of position sizing much earlier in my trading career. It seems a too simple concept but I think most traders DONT fully get it (not because it's too complicated but because they don't pay enough attention to it)

I strongly recommend you find the time to look at this concept!

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Funny thing that it came upon me only after 15 years of trading. Position sizing and random walk theory is all that is needed to succeed over time.

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I read this article again because of the recent TLRY trade. Excellent article. Question for Kim. If I follow this article what is the limit you would use of trades to have open at any one time?? Many Thanks

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I'm trying not to have more than 10-12 positions in the trading account. Of course long term accounts are different. But it's really personal choice, you need to go with what you feel comfortable.

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Thanks Kim. That is helpful for me as I would typically have between 5 and 15 positions open. If you had three calendars open on GS for example at different strikes would you count that as one position or three positions?? and would you try to have a good mix of calendars, hedged straddles, tlt butterfly, RUT, etc in order th reduce risk and diversify??

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Few strikes on the same underlying is considered one position. And yes, the whole point of SO is having mix of strategies that "hedge" each other, and I do it in my personal account as well. Imagine having condors and calendars only and the markets move 5-10% down. Not pretty. Of course tastytrade would say "NEVER buy premium" - but we know better, right?

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