The chance of going bankrupt with a 5% allocation is 1 in 3.49 billion.
Position size is the KEY to successful trading, particularly when you are using a high-probability system.
Without it, you are destined to fail. It’s only a matter of time!
In today’s special edition of The Strike Price, I’m going to cover the importance of position size and its impact on overall returns.
How much should I allocate per trade, if at all? I just never know “how much.” It’s one of the most frequent questions I receive from our readers here at Wyatt Investment Research.
There’s one thing we all can agree on as responsible investors: We don’t want to lose money. So again, I’ve decided to offer some food for thought that I hope will spark a discussion in my seminar on Wednesday.
The killer to trading accounts . . . drawdowns. Higher levels of allocation per trade can lead to unmitigated disaster. Don’t make this mistake. I often see this with those new to trading and it’s unfortunate. Improper allocation can ruin one’s account. Remember, it’s all about a smooth equity curve.
But it never fails . . . inexperienced traders always state that they either “don’t want to miss out” on a large winner or “don’t want to miss out” on that upcoming winning streak.
Don’t allow these thoughts to enter your mind.
Position Size Has Outsized Importance
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 our trades is of the utmost importance. We want to limit the havoc that one trade could have on our portfolio.
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 trades 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.
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.
As you can see from the table above, a 10% loss in the portfolio would need a 11.11% overall gain to make up for the loss.
Emotions Are the Enemy
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.