How much should you allocate to each trade?
This frequently asked question lacks definitive answers. Why? The answer is quite simple; as investors, we all have a different set of goals. There are just too many variables out there (age, income, retirement goals, spending habits, etc.) to give a universal answer to the question.
Options brokers allow you, the investor, the flexibility to allocate your account by specified dollar amount, specified quantity, percentage of available buying power, etc. It is your responsibility to figure out what works with your risk tolerance and investment goals.
This brings us to the important and rarely covered topic of Position Sizing.
To many investors, especially options investors, have a casual attitude toward the management (risk, money) of their investment portfolios. In the constant race for profits, risk management and money management seem to be secondary. The almighty return, the “we want a lot of return, we do not want any risk, and we need the money by Monday” mentality, seems to override the importance of position sizing.
This is particularly true in the options arena. How many websites have you come across that tout outlandish gains with minimal risk with great consistency. All that needs to be said is “think about it”. This does not mean that the typical options investor can’t beat the market by a decent percentage annually. It just means that “shooting for the moon” is not sustainable.
The Gallup organization and UBS recently conducted a survey that found 39% of respondents believed stocks would deliver at least a 15% annual return over the next ten years. This goes to show how wishful thinking consumes a large portion of the investing publics’ attitude toward returns. Historically, the notion of such returns is unreasonable.
“Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I’m getting out before I get in. The position size on a trade is determined by the stop, and the stop is determined on a technical basis.” —- Bruce Kovner
Position sizing is possibly the most important aspect of any options portfolio and trading system. As an investor you must always be aware of risk management (how much you are comfortable losing per trade) and money management (the size of the position per trade).
So, as far as “how much should you allocate to each strategy”, trade, etc., the answers are ambiguous. I can only speak to the strategies I use.
Dr. Van.K. Tharp, in his highly recommended book Trade Your Way to Financial Freedom, discusses in great detail the importance of position sizing. In his book, Dr. Tharp back-tests and compares the effects of different position sizing methods on investment accounts. His tests were based on a trading account of $1,000,000 using a trading system that 595 trades over 5 ½ years.
Here are some of more notable position-sizing methods he compared and the results:
Percent- risk Model
His tests produce some interesting results to say the least and highlight the importance of position sizing. As I have mentioned before, each investor has different risk tolerances and goals. Dr. Tharps results are by no means the “holy-grail” for position-sizing.
Each method has pros and cons under varying market conditions. Ultimately as the investor, you need to create suitable investment objectives that coincide with your risk tolerance.
With that said, go ahead and explore varying ways to use position sizing. Try out different scenarios based on the trades we have placed so far this year. Discover which one fits your investment objectives and stick with it. Remember, investing is not a sprint, it is a marathon.
Overbought/Oversold for November 6, 2007
S&P (SPY) – 50.3 (neutral)
Russell 2000 (IWM) – 46.5 (oversold)
Dow (DIA) – 46.9 (neutral)
Nasdaq 100 (QQQQ) – 60.8 (neutral)
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Andrew Crowder, Chief Investment Strategist, www.crowderinvestments.com