Money Management

Money management is a critical component of the option trading trading system. Trading options without such a plan, you and I would be soon out of the game.

Money management defines how much I will put at risk in my trades. It further gives me a way to systematically apply the same rules every time to how much I risk. Why is this important? How do I know on my next trade whether it will be a winner or a loser? If I knew for an absolute certainty that the next trade was going to be a winner, I would bet the farm right? But if this turns out to be a loser, I just lost the farm.

Let's think about this another way. If I knew that 6 out of every 10 trades would be a winner... but I didn't know which ones, how would I allocate my risk so that I could come out ahead?

What if I was willing to risk $1 with the potential to make $1 and I was right 6 out of 10 times? That means 4 times, I'll lose $1 (for a total of $4 lost) and 6 times I'll make $1 (for a total of $6 gained). Out of 10 trades, I would make $2. On 10 trades risking $1 each time, how much have I risked? A total of $10. If I make $2 for every $10 risked, that's 20% return on my risk.

Reviewing our assumptions

The above money management example was based on a number of assumptions.

  1. I knew what percentage of the time I would have winning trades
  2. I could control how much I could potentially make or lose on each trade
  3. I consistently applied the same reward and risk rules to each trade
For the example, I chose a success rate of 60%. In my personal case, I have a lot of historical data from trading the same basic trade hundreds of times. From that, I can derive a projected success rate (or expectancy).

In my options trading strategies, I've covered different ways to limit risk in a trade. In fact, as I've mentioned in most of my income generating strategies, they are by definition defined risk trades. That means that I know when I put the trade on exactly what I could lose if I did nothing and the trade went against me. In addition, I have ways to further limit risk by exiting early from the trade (providing I exercise the discipline to do so).

This last assumption seems the most obvious and yet is the place where most of us get tripped up. I can't over emphasize this enough (and I say this from experience). The money management rules MUST be followed consistently or one day you will experience a serious shakeup. The kind that could either put you out of the game or cause you to wake up and take your rules more seriously. I'll save a longer rant for another page. But... please develop the discipline to follow your rules consistently.

Money Management Applied

Up to this point, I've talked a little more theoretically about money management. Let's get down to more practical application.

Decide how much to risk on each trade

Depending on what resources you consult, the experts (the ones who have survived in this game for a while) will tell you not to risk more than 1-3% of your trading capital on any one trade. If you've read any of my trading strategies, you may have noted that I've consistently used a maximum loss amount of $1000. That was based on an assumption of trading a $50,000 account and risking just 2%. This is the key part of my money management plan.

What amount should you risk? How much of a loss can you tolerate on any given trade before it keeps you up at night. Don't use a % value until you've converted it to a dollar amount. A % gain or loss won't keep you up at night. Potentially losing $5000 on a trade might.

I've actually found that the larger my account is, the lower my percentage I'm willing to risk on a trade. Why? Because I don't like the idea of losing such a large amount on the trade. This makes me do things like break my trading rules.

Just to be clear then, I would decide on a percentage amount I am willing to risk on each trade. This helps guarantee that my risk amount is sized up or down as my account grows or shrinks.

Once I know what the equivalent dollar amount is for the percentage I am risking, I can then decide how large of a position I can take. Let's say on a given trade, I am risking $.65 per contract (or $65) and I have a $10,000 account I am willing to risk $2% per trade on. The position size would be determined by dividing $65 into my 2% ($200) risk. $200/$65 = 3.07. Whoops... we can't take partial contract sizes. Do we round up or down? You will have to define the rule for that. HINT: A more conservative trader would probaly round down. A more agressive trader might choose to round up any fraction larger than .5.

Decide how much to risk on a given strategy

Once I know how much I will allocate for each trade, I also need to define how much I will risk for a given strategy or set of strategies (for example options trading strategies as opposed to stock strategies). What would happen if I were to place 10 trades in a row risking $200 on each one and they all turned into losers? Could it happen? Of course it could. It may not be likely, but it is a possibility that needs to be considered. Ten trades each losing $200 is $2000 lost. If I was trading a $10,000 account, I just lost 20% of my account. Can I tolerate that?

This is why a maximum percentage risked should be used. So, in addition to risking 2% per trade, I might decide I only want to risk 10% total on income generating options strategies. That means I can only have 5 total trades operating simultaneously.

Decide how much to risk in the market in general

Let's face it. If the market of 2008-2009 has shown us anything, it's that anything can happen. With that in mind, I have to also have decided how much I'm willing to risk overall in the market. This may not be as important if I'm only dealing with $10,000, but when I reach larger amounts, distributing my risk across various markets (stocks, options, real estate, bonds, etc) is a great idea.

With that in mind, I then also need to be thinking about how much of my net worth do I allocate to riskier investments like stocks and options. If I'm younger, I may be able to tolerate risk. As I grow older and closer to my retirement, my tolerance for risking my entire net worth should greatly diminish.

Money management questions that should be answered

With this in mind, the following list of questions should act as a starting point for determining your own money management rules.

  1. What percentage of your account will be risked on every trade?
  2. What rule will you use to resolve fractional contract sizes?
  3. What percentage of your account will you allocate to a given strategy?
  4. How much of your capital will you risk in the market in general?
If you haven't read Alexander Elder's excellent book, "Trading for a Living", I'd highly recommend doing so. At the end of the book, he has a section on risk management and a chapter on money management that is very good. This should serve as a starting point in determining your own money management rules.



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