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The Importance of Position Sizing
Kim posted a article in Trading BlogOur members are familiar with our new "risk free" trade that we introduced a few weeks ago. This is a very low risk and high probability trade, and one of the members posted the following question: The answer is a big NO!!!!!!!!!!!!!!! You never put your whole account into one trade. Our last week trade provided a good reminder why you should never do it. I woke up on Friday with no internet connection - turned out to be a massive Canada wide outage that affected millions of Canadians. A complete network failure - no Wi-Fi, mobile network or phones. While the official trade was close early morning on Friday for a modest loss, I could not close the QQQ combo position on Friday. If I was assigned the short options, it would be not that bad - I would be short 200 shares of QQQ and long 4 calls. In terms of delta, it would be not too directional, and I would just close the shares and the calls at the same time. However, IB algorithm is different from other brokers. This is how it works: This is exactly what happened. Around 15:30, the algorithm determined that assignment of the short calls will cause margin deficiency, and according to their policy, they liquidate most of the short calls (just enough to prevent margin deficiency). The rest of the short calls were assigned, so I was left short QQQ shares and long significant amount of calls. According to Murphy's laws, the markets gapped down today, and I was forced to close the calls for a significant loss. As one of our members mentioned, this is a very useful reminder of how strange events, that 1-in-a-10,000 chance of something happening can result in unexpected losses. What are the chances of there being a Canada-wide outage? What are the chances that it will happen on Friday and last the whole day? This is why position sizing is so important. No matter how safe and low risk the trade looks, unexpected can always happen. If you keep your position sizing under control, you can still recover. This is also a good reminder of how conservative our performance reporting is. If we close (for example) 4 trades per month, each for 5% gain, what gain would we report? Many other services would report a 20% gain - but that means they put the whole account into a single trade. We would report a 2% gain because each trade represents 10% allocation.
How Position Sizing Impacts Your Returns
Kim posted a article in Trading BlogLets 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. 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 Recommended reading: Van Tharp’s Definitive Guide To Position Sizing Money Management Strategies for Futures Traders A Trader’s Money Management System: How to Ensure Profit and Avoid the Risk of Ruin Want to learn how to trade options in a less risky way? Start Your Free Trial
Trade Size: Taming The 800-Pound Gorilla
Mark Wolfinger posted a article in Trading BlogWhat's Your Maximum Loss? However Being confident does not guarantee that the markets will behave Overconfidence leads to ignoring risk management Big size can produce devastating losses The Risk of Ruin increases exponentially as trade size increases Preventing big losses represents the successful trader’s path to wealth Most beginners are shy about making a big monetary commitment and usually start trading with a small investment. When buying options, they set a maximum dollar amount to be invested. It is obvious that the cost of the options represents the most that can be lost. However, when adopting any of the ‘income generating’ strategies, even though the trader may know the results of the worst case scenario, it is often difficult to recognize that such losses do occur. Why is that? I believe it is the result of a natural optimism that accompanies the discovery of options as an investment tool. The conservative trader begins with one-lots. She progresses as her confidence and experience grow. The aggressive trader, who does not (yet) understand how important risk management is to his future success, may begin trading positions that are large enough to destroy 25 to 50% of his account value in a single trade. Let’s take a detailed look at how a trader – especially a new trader – is supposed to determine an appropriate trade size. Hi Mark, I saw your webinar “Can you earn a steady income with Options – The Career Plan.” You discuss a $50k account and suggest that $40k of margin be used, with $10k left for adjustments or other trades. In that $40k you discuss that if we are doing 10-point credit spreads, then the margin required is $1k per spread – so you can take a max of 40 IC’s – so that means if one is doing trades expiring in 2 different months, then that’s 20 IC’s for each expiry. What's the optimal Trade Size? So in short, with a $50k account, a good plan would be to take 20 IC’s in each of those 2 expiring months. ‘Good plan’? That depends on the trader. But, yes, that is what I recommend as the MAXIMUM trade size. It is ALWAYS acceptable to trade less size. It is always safer to keep more money on the sidelines for repairing trades gone awry. One of the worst feelings of helplessness occurs when you are losing money, the market is moving against your position, you see an excellent trade that reduces risk and solves your temporary problem – only to discover that the trade increases the margin requirement and you lack the funds to make the trade. I confess that I did not emphasize that the plan I suggested in the video represents the MAXIMUM trade size. I do not want anyone to believe that an inexperienced trader can handle 40 iron condors when the account size is $50,000. Many experienced traders would find that trade size to be far outside their comfort zones. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Any trader’s individual skill and experience play a large role in determining how much cash you want to hold as a cushion. We must recognize that 20-lots of a 10-point iron condor may not seem too big to handle. And most of the time that is true. However, it is possible to lose as much as $700 or $800 per spread. That unlikely, but possible, loss of $14k to $16k is far too much for a $50k account. Are You An Experienced Trader? The experienced trader; the disciplined trader; the trader who knows that he/she does have the will power to do what is necessary and take appropriate action to insure survival – even it means locking in a big loss; that trader can handle positions of this size. When I refer to a trader who has the will power – I am referring to someone who has done it – more than once. It is far too easy for the less-experienced trader to look at a $5,000 loss and refuse to accept the fact that a given trade is not going to work. The trader who hates losing that much and wants ‘his/her money back’ is not going to be a successful trader. When money has been lost, it is no longer your money. It belongs to someone else. That traders JOB is to salvage his account by fixing the problem. That is accomplished by exiting the trade, reducing size, or making a risk-reducing position adjustment. If you do not know FOR A FACT that you will have the courage – and it does take courage to face reality – that you will act to prevent larger losses and that you will not just close your eyes and hope that the market reverses direction – then you are not yet ready to trade bigger position size. Have patience, gain experience, and trade far below the recommended maximum. I repeat: I did not emphasize those points when making that video. The video discussion was about the minimum amount of spare cash an iron condor trader should keep available. More cash increases the probability that you be able to handle any crisis and survive for the long term. I do understand that you will probably never lose the maximum, because you would adjust and reduce risk. However, are you positive that you would not panic or refuse to act? Do you really want to bet your entire trading account on that possibility? We recognize that the maximum loss is possible if the market crashes, and we do want to think in terms of a worst-case scenario when looking at risk. But one note: If the market crashes, IV will be sky high. Those very deep ITM put spreads will not be trading near $10. You would be able to cover at a price of $7 to $9. You may not want to do that, hoping for a reversal, but the maximum loss would not occur right away, unless it is expiration day. The way I have read about managing risk is to decide how much you are going to risk on each trade. So let’s say I had a $50k and I decide I will not risk more than 4% per trade – so 4% of 50k is $2k. In the above scenario where the risk per IC was $820 I would only do a maximum of 2 or 3 IC’s ($2k divided by $820). Could you advise the pros and cons of each – surely the 20 IC’s will provide much higher return. Yes, the cash returns could be very high. But more than that, the loss potential is also high. Too high in my opinion. As far as risking 1, 2, or 4% of the account value on a trade, that is not for traders who do as we do. That is for the day- or swing-trader or who buys stocks (futures etc). We can take a little more risk per trade because the chances of losing the maximum are very small. That is not true for the day trader. That day trader (or investor) could establish a stop loss at that 2% or 4% level. Losing that maximum is not a rare situation. Similarly, an investor who follows your suggested rule could own more than 20 simultaneous investments. That works for the longer-term investor who does not have to make moment-to-moment trade decisions. We, and our positions, do not allow for convenient stop loss orders (for many reasons). But that does not mean we should go as far as putting 16k (32% of the account) at risk for any trade. We need a more reasonable limit. I am comfortable telling you that if you own two 10-lot iron condors – that is reasonable trade size despite the possibility of losing $8k on each spread, IF AND ONLY IF You are comfortable with that size You have experience making adjustments and taking losses You are not nervous with that size (within comfort zone) If it is early in your career, I would be more comfortable suggesting that you trade two three-lots positions. Related articles: Trading An Iron Condor: The Basics Trade Iron Condors Like Never Before Why Iron Condors are NOT an ATM machineWhy You Should Not Ignore Negative Gamma Are You Ready For The Learning Curve? How Position Sizing Impacts Your Returns Adaptability And Discipline Want to learn how to reduce risk and put probabilities in your favor? We discuss how to do it on our forum. Start Your Free Trial