“He who thinks he knows, doesn’t know. He who knows that he doesn’t know, knows.” Lao Tse
In this email, we will talk about Position Sizing in Options Trading – one of the most important concepts that will stop you from going broke on your first trade!
Position sizing is simply the how much of trading. It answers the question such as “How many contracts or shares per trade you should buy for your account size?”.
When you enter a position, it is essential to know the point at which you will get out of the position in order to preserve your capital. This is your “risk”. It is your worst-case loss – except for slippage and a runaway market going against you. One of the most common position-sizing systems involves controlling your per trade size as a function of this risk.
There are various Position-sizing model. In this email we will discuss position sizing based on Percent-Risk model.
To implement position sizing concept you need to know three variables. These are your portfolio size, risk tolerance percentage and stop loss percentage. Risk tolerance is defined as how much you are willing to lose on one trade as part of your total portfolio amount. Stop loss is defined as how much you are willing to lose in a given trade. Please make sure to understand the difference between the two.
To illustrate position sizing lets assume your portfolio size is $50,000. Lets also assume that you do not want to risk more than 2 percent of your capital in any trade. This means you are willing to lose $1000 ($50,000 * 0.02) on one single trade. Lets say that based on your technical analysis you have determined that your stop loss percentage will be around 50 percent.
Lets take the example of AAPL. You are bullish in AAPL and are interested in buying AAPL Calls as you think AAPL will rise in price. Lets assume one AAPL Call contract is trading at $20. Since one contract controls one hundred share, therefore, purchasing one contract of AAPL at $20 will require $2000 ($20 *100) investment. As we know not all trades are successful and they hit our stop loss. Your technical analysis tells you that when AAPL trades at a certain price your Call contract will be trading at $10 thus you will incur 50 percent loss. This is your stop loss percentage. In other words you will lose $1000 ($10 *100) in this trade which is 2 percent ($50,000/$1000) of your starting capital.
In other words your risk is defined as 2 percent and your stop loss is at 50 percent. Therefore based on your portfolio size of $50,000 you should not invest more than $2000 in AAPL trade. This investment amount is calculated as follows.
Investment Amount = (Portfolio Size/Stop Loss Percentage) * (Risk Tolerance)
Investment Amount = ($50,000/0.5) * (0.02) = $2000
The above equation for determining the Investment amount shows that if we increase the risk tolerance while keeping the Portfolio size and Stop Loss Percentage same we would be able to investment more in AAPL trade.
For example, if we increase risk tolerance percentage to 4 percent then the investment amount as determined by the equation will be $4000 calculated as follows:
Investment Amount = ($50,000/0.5) * (0.04) = $4000
Similarly you can keep the risk tolerance to 2 percent but if you decrease the stop loss percentage to 25 percent then you would be able to invest $4000 in AAPL trade and is calculated as follows:
Investment Amount = ($50,000/0.25) * (0.02) = $4000
As you can see your Investment amount in a single trade is a function of your portfolio size, risk tolerance percentage and stop loss percentage. It is suggested that risk tolerance level should remain constant (e.g. 2 percent) whereas your stop loss percentage and your portfolio size will fluctuate from time to time.
As your portfolio size increases or decreases your investment amount per trade has to be adjusted accordingly based on your risk tolerance and stop loss percentage. Lets say your portfolio has grown to $60,000. Keeping risk tolerance and stop loss percentage same we would be able to invest $2400 in our AAPL Calls which is calculated as follows:
Investment Amount = ($60,000/0.5) * (0.02) = $2400
Based on $2400 investment if you lose in this trade the loss amount would be $1200 which is 2 percent of your portfolio size.
In summary proper position sizing will eliminate fear level, rate of errors and will build your confidence in trading. This will lead you to improvement in your success rate, and higher profits in gradual systematic way. Above all few bad trades will not wipe out your account and you will live to trade in the future.