Sizing Risk (Part I)

In my last post on profit factor (http://www.optionfanatic.com/2012/04/24/introduction-to-profit-factor/), I mentioned that one way to run a viable trading business it to keep the average loss somewhat equivalent to the average gain.  Sizing risk is a sneaky impediment to consistent profitability that describes the potential for larger losses with more capital employed and also to the potential for smaller gains with less capital employed.

A typical positive theta option trading plan involves scaling with a 15% profit target and 20% max loss. The trade is initially placed with 1/3 total capital.  As the market moves against the trade, another 1/3 of the total capital is deployed as an adjustment.  If the market continues to move against the trade, the final 1/3 of capital is deployed.

In periods where the market moves sideways, the trade will hit its profit target with only one-third total capital utilized. In more challenging times, all capital will be deployed.  When the 20% max loss is hit, it will be 20% of the full capital deployment.  When the profit target is hit, it may be on 33%, 67%, or 100% of total capital allocation depending on whether any scaling was necessary.  In effect, then, this trading plan has a max loss of 20% with a profit target of 10% (the average of 33% capital allocation * 15%, 67% capital allocation * 15%, and 100% capital allocation * 15%).

Before I go into why this results in a challenged trading strategy, I need to make a detour.  The logical response would be to hold the trade until 15% profit is realized on total capital whether or not total capital is committed.

In my next post, I will begin to traverse this detour with a discussion of negative gamma risk.