Sizing Risk (Part III)

Sizing Risk is a common trading plan element that can pose a challenge to consistent profitability.

As discussed in Part I (http://www.optionfanatic.com/2012/04/26/sizing-risk-part-i/), these are scaling trading plans with a profit target of 15% and max loss of 20%.  Suppose $10,000 is allocated per tranche for up to three tranches.  The trade will then profit $1,500, $3,000, or $4,500–fifteen percent–depending on how many tranches are placed. When the trade loses, it will usually be after completely scaling in: 20% of $30,000 is $6,000 lost.

This monthly trade will therefore have to profit at least 75% of the time to be profitable.  If the trade wins eight months out of 12 and averages two tranches for each winning month then in one year it will make 8 months * $3,000/month = $24,000 and lose 4 months * $6,000/month = $24,000.  If the trade only wins seven months and loses five months then the annual return will be -30%.  Should it have a tough year and lose exactly as often as it wins, the annual return will be -60%, which is nothing less than a good recipe for grounding an account into hamburger meat.

As discussed in my posts on the naked put selling strategy (http://www.optionfanatic.com/2012/03/25/the-naked-put-part-iii/), a common worry amongst traders is to have one catastrophic loss that wipes out many profitable months. Sizing Risk teaches us that making too little in the winning months can be just as harmful to overall returns as catastrophic losses but is much more frequently overlooked.