Intelligent money management strategies for option traders
In this article, we will discuss the nuts and bolts of money management for option traders. This provides some generic advice to any aspiring option traders who want to make a living out of option trading. In general, we will discuss:
- The mathematics of recouping losses
- Conservative money management strategies to limit losses
- Considering the risk and reward ratio in a trade
An option trader has $100,000 in his account. He analyses the technical charts of ABC Corp and looks for clues that there will be a significant price move to the upside over the rest of the year. He also predicts that there will be a dividend hike as the company has just sold off some of its real estate assets, booking a huge profit in the prior fiscal year. He is confident that there will be a big price move to the upside. The price of ABC currently trades at $50. He decides to buy at the money long term call options which comprise of 50% of his trading account. In essence, he spends $50,000 on this one trade.
What happens next proves to be devastating. The underlying security makes a significant move downwards as the company’s CEO is investigated for fraud. Also, amidst the fiasco, no dividend hike was announced. The price of the stock makes a dive to $10.
At this point in time, the trader’s call options become worthless. And he loses 50% of his trading account. In absolute terms, he loses $50,000 and he is only left with $50,000 in his trading account.
Now that the trader has lost 50% of his funds in the trading account, he only has $50,000 left. Do note that the percentage of money that he has lost is 50%. Now, how much profit must he make in order to get back to initial capital of $100,000? He must earn $50,000 of profit and he must earn it with the remaining $50,00 of capital in his tracing account.
In percentage terms, the trader must earn:
$50,000/$50,000 x 100% = 100%
While the trader lost 50% of his trading account with that one trade, subsequently, the trader must earn 100% on the remaining capital in order to get back the trading account to its initial capital of $100,000. For experienced traders, they know that it is extremely difficult to earn 100% on the remaining capital.
So the case in point is this. For whatever percentage loss that a trader incurs, the trader must make a larger percentage increase to get back to the same level of capital.
Based on the above example:
Percentage loss initially is = 50%
Percentage profit must be = 100%
The above scenario is a nightmare scenario for beginner traders. This is not something that beginner traders should experience. Though there are a few mistakes that the trader has made, the main mistake is that he has committed too large a percentage of his money into 1 single trade. When the trade turned against him, he lost all his money as the options expire worthless.
Limit the quantum/size of the trade
What the trader should have done instead is to limit the size of his trade to a manageable $5000 or 5% of the $100,000 capital. If that had happened instead, the trader would have only lost $5000. He is still left with $95,000 of capital.
Increase the quantum of the trade with high probability odds
When considering a trade with high probability odds of profit and a favorable risk reward ratio, a trader can choose to put more of his capital at risk. A favorable event will mean that he would realize a greater profit.
Survive the game of options trading
To be an option trader, one must have capital. Without capital, the trader will be unable to make further trades. The whole idea here in fact is to preserve capital first, then making profits. In the hypothetical example above, the trader thinks about the profits but ignores the risk of a loss.
The risk of loss must be factored into the decision making process. If the worse case scenario occurs, a trader must be able to stomach it and still be able make other trades. If the worse case scenario occurs and causes a permanent reduction to the capital of the trader such that it limits the trader’s ability to trade, then, that risk is not an acceptable one.
Consider the trader that has $10,000 to trade with.
Scenario 1 – The trader uses $500 to make a trade and loses it entirely
Scenario 2 – The trader uses $9500 to make a trade and loses it entirely.
In scenario 1, the trader would have $9500 to make further trades while in scenario 2, the trader only has $500 left to make further trades. Scenario 2 is one with unacceptable risk.
5% money management rule
For the reasons above, it is very important to limit the loss of a trade. Hence, a rule of thumb is to place only 5% or less (a small percentage) of the capital into a single trade. If the trader’s capital is just $10,000, the trader places only $500 into 1 trade.
As the trader’s account grows, with the 5% rule, he is able to employ more resources to each trade. For example, if the trader’s account has grown to $40,000, he would put $2000 into a single trade. This is reasonable because if his account has grown, that also means that he has garnered a winning track record and would mean that he has a greater confidence of earning a profit than before.
If a trader’s account shrinks to $5000, according to the 5% rule, he would only be able to commit $250 to a single trade. Once again, this is reasonable as it makes sense for the trader to cut back when he is on a losing streak.
Risk reward ratio
The trader should make trades that have risk reward ratios which are in his favor. For example, if a trader has $10,000 to trade with.
In scenario 1, he uses $1500 to make 3 trades, $500 in each of his trades.
Consider that the risk reward ratio is $1 of potential loss to $2 of potential profits. If the trade makes a complete loss on 2 of the trades and only makes a profit on 1 trade(profit of $1000 on this trade based on the above risk reward ratio), the trader’s account will have an ending balance of $10,000.
There is no profit or loss in this instance.
Now, the trader uses $1500 to make 3 trades where $500 is put into each trade. Consider that the risk reward ratio is $1 of potential loss to $5 of potential profits instead. If the trader loses on 2 trades but earns on the third trade(a profit of $2500), the account will have an ending balance of $11500. The trader’s account has grown. There is a realized profit of $1500 on his starting capital of $10,000.
Therefore, a trader must look for risk reward ratios which are in the trader’s favor.
Automatic stop losses
A trader should also use automatic stop losses backed by intelligent technical analysis to limit the loss in a trade. An automatic stop loss forces a trader to exit a trade when the trade turns against him, thereby, preventing the trader from becoming emotionally attached to his trade and turning it into a long term investment.
Periodic audits and a 20% maximum loss on account capital
A trader should conduct regular monthly audits of his trading account. This can be conducted on every 3rd Saturday of the month. The trader should take note of the total value of the account which includes the current market value of all open positions and unutilized cash.
If this value reflects a greater than 20% loss in his capital, the trader should stop trading and reflect on what has been done wrong and what could have been improved. These events should be recorded in a trading diary. A period of rest is necessary for the trader to regain his sharpness. In fact, professional traders are given a break when they have made repeated losses on their trades.