Sizing Risk (Part I)
Posted by Mark on April 26, 2012 at 10:08 | Last modified: April 26, 2012 10:08In 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.
Tags: income trading | Categories: Money Management, Option Trading | Comments (2) | PermalinkPrevent Huge Portfolio Losses
Posted by Mark on March 14, 2012 at 13:07 | Last modified: March 20, 2012 08:28One key to success in trading and investing is to prevent huge portfolio losses. If you lose 50% of your portfolio, for example, then you have to gain 100% just to get back to even. Off the top of my head, I can think of three ways to limit huge portfolio losses:
1. Diversify
What this really means is to include uncorrelated assets in your portfolio. “Uncorrelated” means prices tend not to move in sync. For example, if one goes up, the other goes sideways or down. Alternatively, if one goes way down then the other goes up, sideways, or down a little.
The danger of diversification is that in extreme circumstances correlation can go to 1, which means everything moves together. You could be invested in markets that had historically been uncorrelated but when the crash hits, everything goes down. We saw this in fall 2008 when gold, bonds, and the stock markets all fell precipitously for a while.
2. Position size to limit total exposure.
If you are only 10% invested then the most you could ever lose if that asset (e.g. stock) goes to zero is 10%. The remaining 90% of your portfolio would be in cash.
3. Buy puts
Put options profit when their underlying markets fall. Options were originally created to serve as insurance and this is exactly what long puts can do.
Other ways of achieving this goal are to short markets or to buy inverse ETFs.
Tags: survival | Categories: Money Management, Option Trading | Comments (0) | PermalinkStow Your Ego Before Trading
Posted by Mark on March 6, 2012 at 15:58 | Last modified: March 14, 2012 13:10Here’s a worthwhile quote from acclaimed systems developer Thomas Stridsman:
“It is only a question of how long you stick around. If we all stick around long enough the probabilities have it that we all will be wiped out sooner or later. It is just a matter of time.”
Once upon a time, I lost 50% of my total net worth in a span of less than two weeks.
Been there done that and hope to never live through such an experience again.
Tags: drawdown, survival | Categories: Money Management | Comments (0) | Permalink