Here are some questions you should ask:
- In order to make the 100%, how much do you risk?
- How much of your capital do you allocate for those positions?
- How much time do you give the trade to develop?
The first two questions are directly related to position sizing.
Consider the 2% rule described in Dr. Alexander Elder's excellent 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.
If you adapt the 2% rule and the risk in your trade is 50%, then you can allocate 4% of your account for that trade. If your risk is only 20%, then you can allocate 10% to that trade.
So here is another question:
Which one is better - one 100% winner which risked 50% and took one week to achieve or seven 10% winners which risked 20% and took one day each?
If you followed the 2% rule and allocated 4% of your account to the first trade, it contributed 4% to your account. But you could allocate 10% to each of the seven 10% winners, so they contributed a full 7% to your account during the same week.
Our trading strategy is based on consistent and steady gains with holding period of few days to few weeks. Those are not Home Runs, but most of our trades had very low risk, hence you could allocate 10-15% of your account to each trade. Make ten such trades each month with average return of 10% per trade, and your account is up 10% per month.
Here are some conclusions:
- There is more than one way to trade options.
- Position sizing is one of the most important elements of trading, especially options trading.
- Few small winners achieved with low risk might be better that one big winner achieved with higher risk.
What is really important is not an occasional 500% winner, but an overall trading plan. What really matters is the return on the overall account. Next time someone tells you how he made 500% in an options trade, please ask him the following questions:
- How many trades you make every month on average?
- How much do you allocate per trade?
- How much do you risk per trade?
- How many trades do you have open on any given time?
- What is the average duration of the trades?
- What is your winning ratio and average return per trade?
- What is an average monthly return on the whole account using your strategy?
If you learn to ask the right questions, you can avoid the hype and properly evaluate an options strategy in context of the overall portfolio return.
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