What You Should Know About Position Sizing in Options Trading – Part 2

Money management is a very confusing term. When we looked it up on the Internet, the only people who used it the way that Van was using it were the professional gamblers. Money management as defined by other people seems to mean controlling your personal spending; giving money to others for them to manage, risk control, making the maximum gain, plus 1,000 other definitions.

To avoid confusion, Van elected to call money management “Position Sizing.” Position sizing answers the question, “how big of a position should you take for any one trade?”

Position sizing is the part of your trading system that tells you “how much.”

Once a trader has established the discipline to keep their stop loss on every trade, without question the most important area of trading is position sizing. Most people in mainstream Wall Street totally ignore this concept, but Van believes that position sizing and psychology count for more than 90% of total performance (or 100% if every aspect of trading is deemed to be psychological).

Position sizing is the part of your trading system that tells you how many shares or contracts to take per trade. Poor position sizing is the reason behind almost every instance of account blowouts. Preservation of capital is the most important concept for those who want to stay in the trading game for the long haul.

Imagine that you had $100,000 to trade. Many traders (or investors, or gamblers) may just jump right in and decide to invest a substantial amount of this equity ($25,000 maybe?) on one particular stock because they were told about it by a friend, or it sounded like a great buy; or perhaps they decide to buy 10,000 shares of a single stock because the price is only $4.00 a share (equating to $40,000).

They have no per-planned exit or idea about when they are going to get out of the trade if it happens to go against them and they are subsequently risking a LOT of their initial $100,000 unnecessarily.

To prove this point, we’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities, with the exception of those who go bankrupt. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million–yet everyone started with $100,000 and they all got the same trades.

Position sizing and individual psychology were the only two factors involved.

Van says that this just shows how important position sizing is.

So how does it work?

Suppose you have a portfolio of $100,000 and you decide to only risk 1% on a trading idea that you have. You are risking $1,000.

This is the amount RISKED on the trading idea (trade) and should not be confused with the amount that you actually INVESTED in the trading idea (trade).

So that’s your limit, you decide to only RISK $1,000 on any given idea (trade). You can risk more as your portfolio gets bigger, but you only risk 1% of your total portfolio on any one idea.

Now suppose you decide to buy a stock that was priced at $23.00 per share and you place a protective stop at 25% away, which means if the price drops to $17.25 you are out of the trade. Your risk per share in dollar terms is $5.75. Since your risk is $5.75, you divide this value into your 1% allocation (which is $1,000) and you are able to purchase 173 shares, rounded down to the nearest share.

Work it out for yourself, so you understand that if you get stopped out of this stock (i.e., the stock drops 25%), you will only lose $1,000 or 1% of your portfolio. No one likes to lose, but if you didn’t have the stop and the stock dropped to $10.00 per share, you can see how quickly your capital vanishes.

Another thing to notice is that you will be purchasing about $4000 worth of stock. Work it out for yourself. Multiply 173 shares by the purchase price of $23.00 per share and you’ll get $3979. It would probably be around $4000 when you add commissions.

Thus, you are purchasing $4000 worth of stock, but you are only risking $1000 or 1% of your portfolio.

And since you are using 4% of your portfolio to buy the stock ($4000), you can buy a total of 25 stocks this way without using any borrowing power or margin, as the stockbrokers call it.

This may not sound as “sexy” as putting a substantial amount of money in one stock that “takes off,” but that strategy is a recipe for disaster and very rarely happens. Therefore it is best left on the gambling tables in Las Vegas.

To continue to trade and stay in the markets over the long term, learning position sizing and protecting your initial capital is vital.

Van believes that people who understand position sizing and have a reasonably good system can usually meet their objectives through developing the right position sizing strategy.

Position Sizing–How much is enough?

Start small. So many traders that are trading a new strategy start by risking the full amount that they plan on using for the long term with that strategy. The most frequent reason given is that they don’t want to “miss out” on that big trade or long winning streak that could be just around the corner. The problem is that most traders have a much greater chance of losing than they do of winning while they learn the intricacies of trading the new strategy. Therefore, start small (very small) and minimize the “tuition paid” to learn the new strategy. Don’t worry about transactions costs (such as commissions), just worry about learning to trade the strategy and follow the process. Once you’ve proven that you can consistently and profitably trade the strategy over a meaningful period of time (months, not days), then you can begin to ramp up your position sizing.

Manage losing streaks. Make sure that your position sizing algorithm helps you to reduce the position size when your account equity is dropping. You need to have objective and systematic ways to avoid the “gambler’s fallacy.” The gambler’s fallacy can be paraphrases like this: after a losing streak, the next bet has a better chance to be a winner. If that is your belief, then you will be tempted to increase your position size when you shouldn’t.

Don’t meet time-based profit goals by increasing your position size. All too often, traders approach the end of the month or the end of the quarter and say, “I promised myself that I would make “X” dollars by the end of this period. The only way I can make my goal is to double (or triple, or worse) my position size. This thought process has led to many huge losses. Stick to your position sizing plan!

We hope this information will help guide you toward a mindset of capital preservation on your journey toward successful trading.

“I have talked to many folks who have blown up their accounts. I don’t think I have heard one person say that he or she took small loss after small loss until the account went down to zero. Without fail, the story of the blown up account involves inappropriately large position size or huge price moves, and sometimes a combination of the two.” ~D.R.Barton

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