The Most Important Concept in Options Trading

options-trading-position-size

Proper Position-Size in Options Trading

It doesn’t matter if you are just starting or have an advanced grasp of all things options, if you don’t think of yourself as a risk manager first, you will fail, it’s just a matter of time.

Proper risk management is what separates those that succeed from those that continually struggle or simply just give up.

What people continue to struggle with is trying to find the latest and greatest strategy, constantly hopping from one strategy to the next. Strategy is far less important, than proper risk management.

Placing trades, well, it’s the easiest part of the trading process. Anyone can place a trade. It’s how you handle the trade that allows you to be profitable over the long term.

Which is why you MUST think of yourself as a risk manager first, especially if you are taking a truly quant-based approach. The law of large numbers is your foundation but managing sequence risk is the obstacle that most traders just can’t overcome.

Sequence risk is the inherent risk that a trader could suffer multiple losses in a row. The best way to combat sequence risk is through proper position sizing. Position sizing mitigates the impact of consecutive losses. The lower the capital risked per trade, the lower the probability that a sequence of losing trades will cause a significant drawdown.

The table below shows how sequence risk can impact your overall account and why it is imperative that you use proper position size when investing/trading.

sequence-risk-position-size

Again, we know losing trades are going to occur. It’s a hard fact that we must accept. So, trades must be managed appropriately. And the first step is proper position size.

The most important decision you will make as a successful options trader is how much to allocate per trade. From a risk-management standpoint, maintaining a consistent position size among your trades is of the utmost importance. We want to limit the havoc that one trade could have on our portfolio.

account-balance-position-size

For simplicity’s sake, let’s say our trading account stands at $10,000 in this example.

In one case, we have allocated 50% per trade. In the other, we have allocated 5% per trade.

$10,000 Account (50% allocated per trade):

One position, equally weighted at $5,000. So, with each trade, a 10% drop will cause a 5% drop in our overall portfolio. A 20% drop will cause a 10% drop, 30% would be 15% . . . you get the picture.

Just knowing this gives every options trader the insight necessary to shape a position size and stop-loss strategy for maximum effectiveness.

Let’s say with each trade we set our stop-loss order at 50% of our allocated amount. For example, with 50% allocated to each trade, out stop loss would be set at $2,500.

Two trades would only allow us to diversify among two positions with 50% of our overall portfolio value at risk.

$10,000 Account (5% allocated per trade):

One position, equally weighted at $500. So, with each trade, a 10% drop will cause a 0.5% drop in our overall portfolio. A 20% drop will cause a 1% drop, 30% would be 1.5% . . . again, you get the picture.

Our stop-loss with 5% allocated per trade is $250.

For example, if we had four iron condor trades open simultaneously, we would have $2,000 in play with only $1,000 or 10% of our overall portfolio at risk.

Worst-Case Scenario

If we assume our position size of $500 per trade and had four trades going at one time, our maximum loss is 10% or $1,000 of our overall portfolio.

A 10% loss in the portfolio would need a 11.11% overall gain to make up for the loss.

Summary

I realize the prior exercise is fairly simplistic. Again, it only begins the important discussion of money management. Without some form of money management, emotions take over.

And emotions are the enemy. Hindsight never exists in the present. We must realize that we will be wrong on occasion.

Being privy to this allows us to prepare accordingly. We know over the long term that having a defined stop loss will only serve to benefit the performance of our respective portfolios. More importantly, we always know when to sell. Of course, all of the above assumes that we prefer the straight percentage stop-loss.

If you want to be a successful trader/investor over the long term, then taking the time to figure out an appropriate position-sizing plan is imperative. Please, please, please do not overlook this important concept.

You will not regret it.

 

4 comments on “The Most Important Concept in Options Trading

  1. Ken Adams on

    Hi Andy, I opened a Bear Call Spread on SPY expiring 11/19/21. The spread is 455/460. With SPY currently at $456 and trending upward, do you recommend taking any action this week? Thanks.

    Reply
    • Andy Crowder on

      Ken,

      I can’t really give any personal advice. I will say that as long as you keep your position-size in check and are disciplined with your stop-losses you will be fine when the occasional losing trade occurs…and they will occur. SPY is currently very overbought, so I’m actually looking for a short-term reprieve over the next several trading days/weeks, but again, no one has a crystal ball which is why risk-management is so important.

      Reply
  2. Ahmad Mohammad on

    A very eye-opening article on the most important aspect of options trading. Thanks Andy for giving us all the details and concepts about the importance of position sizing and its vital role in the survival of a trading account. Human emotion of greed and quick profit tempt us to take much larger position size on a specific trade and if that trade result in losses it can be catastrophic for the trading account. Please keep us educated about this subject in your future articles, shining a light on other aspects of position sizing. Thanks a lot again. Your insights and ideas are greatly helpful and deserve great appreciation for us all readers.

    Reply
    • Andy Crowder on

      Ahmad,

      Thanks for all the kind words and you are very welcome. I’m glad that you are finding everything so helpful. Happy trading!

      Reply

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