Sizing Risk (Part II)

In Part I on Sizing Risk (http://www.optionfanatic.com/2012/04/26/sizing-risk-part-i/), I described a scaling strategy that aims for a 15% profit target and 20% max loss.  Because allocated capital may remain on the sidelines, the strategy actually aims for a 10% average profit target with 20% max loss.  This lowered profit target raises a challenge to profit factor because it loses even more in bad months than it profits in good months.

If the trade reaches 15% profit on 33% or 67% of allocated capital then why not hold the trade until it reaches 45% or 22.5% profit respectively, which would be the same net profit as 15% on 100% of allocated capital?

On certain days, a profit target may be hit when IBM trades within a price range.  For example, to hit the 22.5% profit target on trade day 12:

IBM must trade within a range only 22% as wide (red line) as it must trade to hit the 15% profit target (yellow line).

In the table below, Columns B, C, and E describe the range of price ($) in which IBM must trade to hit the three profit targets:

Out of 16 total, the 15%, 22.5%, and 45% profit targets may only be hit on 10, 8, and 4 trading days, respectively.  As profit target increases, fewer days are available to hit the target.

Next, study Columns D, F, and G, which compare the magnitude of price ranges over which profit targets will be hit.  I made a Day 12 comparison with the red and yellow lines, above.  Columns F and G indicate that on two out of the four days when the 45% profit target may possibly be hit (Days 18 and 19), the price range is 52% as wide or less than that required to hit the lower profit targets.

Not only do higher profit targets allow for fewer days when price targets may be hit, they also mean for a lower chance of hitting targets on those days.

My last post on negative gamma risk (http://www.optionfanatic.com/2012/04/27/undressing-negative-gamma-risk/) explains this.  As option expiration approaches, routine changes in stock price can cost us more and more money–potentially even turning a nicely profitable trade into a loser at the last moment.

This is the argument against holding a modestly profitable trade longer in an attempt to hit the higher profit targets.