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Option Basics - Position Size

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If you are new to options, please read our Option Basics - Part 1 (through 4) to get a good start in your option education; or go to our site Options Annex - Option Basics.

The reason most traders wipe out their accounts, whether trading options or other assets, is largely due to trading too large (or too high a percentage of their account). Understand that when trading directionally (that is, expecting to make a profit if the underlying asset moves in a specific direction of up or down) your probability of profit (POP) is 50% or less. The 'less' occurs when placing stop orders that are closer to the underlying asset's price than the profit target; this generally occurs when risking $1 to make $2 or more.

This is true because the shorter the duration of your trade, the more random will be the price action of the underlying asset (assuming there is no unique news event that changes expectations for the underlying asset) . So if your trade lasts less than a week or two, it is more likely that your stop order will be hit before your profit target is hit.

Therefore, our primary goal as a trader is to ensure that our trading account survives losing trades, and this is accomplished through position sizing.

Position sizing is a two step process. First, we identify risk; not just in terms of probabilities, but in terms of maximum capital at risk. And second, we determine position size that limits our max loss to an acceptable percentage of our account.

The percentage guidelines vary depending on trading style. For example, if we trade often putting on many positions concurrently, then the typical guideline for position size is to risk no more than 2% of the account size on any one trade, and that the maximum size of the account that is fully invested be less than 50%.

However, if only one trade is placed at a time, then the position size for a single trade would be dependent on the probability of max loss. By keeping the probability of max loss at 2% or lower and the capital at risk below 50% of account size, you will have achieved the same results as the above guideline for many concurrent trades.

The average expected loss over many trades with either style of trading would be 1% (2% x 50%) of account size. Another consideration is the probability of consecutive losing trades with the latter trading style (one trade at a time). If the POP is 95% (using option credit spreads), then the probability of consecutive losses over many trades is as follows: 2 losses = 1 in 400; 3 = 1 in 8k; 4 = 160k (where k = 1,000s); if the POP is 50%, then the probability of consecutive losses over many trades is: 2 losses = 25%; 3 = 12.5%; 4 = 6.25%.

In conclusion, planning position size in advance of the trade will help avoid major losses from wiping out your account.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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