Options Trade Sizing

In my previous post we talked about how to use stops with defined risk trades. Now one key to that strategy is appropriate trade sizing. As with any type of trade, trade sizing is key to your success. Now before I get into the aspects of trade sizing I want to touch on probabilities. Much of my options trading is based on probabilities and a key aspect of making probabilities work is to a have large enough number of traders (occurrences). This is known as the law of large numbers. To understand the law of large numbers lets take look at a coin flip. As everyone knows a coin flip has a 50-50 probability for heads and tails. Now intuitively we know that if you flip a coin 100 times you have a better chance of getting a 50-50 outcome then if you flip a coin only 10 times. The probabilities bear this out. If you flip a coin  4 times you have a 6% probability of getting 4 all heads in your flip. Now flip the coin 10 times and that number drops to .097% and flip it 100 times and the number becomes infinitesimal.  Baseball offers excellent examples of how statistics and probabilities work out. For instance a career .250 hitter can hit .350 over a short period of time but over the length of the entire season (a larger sample size) they will average closer to .250. Another good example is to look at casino’s. Casino’s  prefer large numbers of small bets versus a small number of large bets. Since they have the edge, similar to options sellers, they want to make sure the probabilities work out so they want to use the law of large numbers. That is why you see large numbers of small bet tables and machines. If you are interested in probabilities and entertaining book (if you can say that about probabilities) is The Signal and the Noise; Why So Many Predictions Fail – but Some Don’t by Nate Silver, who is a statistician and correctly predicted the last two US elections and writes the fivethirtyeight blog for the New York Times.

Now how does this relate to trade sizing? Well first, in order to have a large sample size we need to place many trades per month while not using all of our capital. We don’t want to use all our capital as we need capital available to manage and defend positions as well as have dry power for any unique opportunities that may arise.  Additionally as we move from one expiration cycle to the next we need capital available to start placing positions for the next expiration cycle while still managing positions in the current cycle. So to stay small and have the ability place lots and lots of trades I typically limit the amount of capital used for each trade to 1-3% of my available capital. Assuming a $100K account size at 1% you can have 50 positions on if you’re using using 50% of your total available capital. This also means that during an expiration cycle you could easily have 75 – 100 trades placed which will have the probabilities work for you.

Now you may be saying, “Well that’s great but I don’t have a $100K account”. Not to worry, you can still place enough trades to get the law of large numbers working for you. With a $25K account (the pattern day trading minimum) you can easily have 12-15 positions on at any one time and only use 50% of your capital. This will allow you to typically have between 20-40 trades per expiration cycle which is enough trades to have the probabilities work out.

By placing many small trades and getting the probabilities to work for us we greatly increase our overall success as a trader. Now with this type of trading you are not going to hit many home runs and we are never going to risk a large portion of our account in a trade to try to strike it rich. Instead we are going to consistently make steady profits and grow our account over time. Keep in mind that if you earn only 8% per month on your account that equates to approximately 100% on an annual basis, not too bad. And to make the 8% on your account you only need to earn 16% on the 50% you use as capital, a very reasonable figure. This requires us to change our mindset from thinking about how much we can make in any single trade (get rich quick) to focus on managing our return on capital for each trade (how professionals trade). To use another baseball example we don’t want to the guy that hits 40 home runs but bats .180 and strikes out 300 times.  We want to be the person that hits .400 and leads the league in total bases.
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