How much should one allocate to any given trade?
The 2% – 6% rules have been introduced in Dr. Alexander Elder’s book “Come Into My Trading Room” The 2% rule is to protect traders from any single terrible loss that can damage their accounts. With this rule traders risk only 2% of their capital on any single trades. This is for limiting loss to a small fraction of accounts.
Besides a disastrous loss, a series of losses can also damage traders’ account. The 6% rule is lent to handle this. Traders have to set the maximum of accumulated loss for a month. When they reach that level of loss, they have to stop opening any new position for rest of the month.
These 2 rules are designed to protect traders from the two types of losses. For those who are able to accept the higher risk, they might adjust the 2% – 6% rules to 5% – 10%, where the 5% is used to protect the account from any single disastrous loss while the 10% rules is used to protect traders from any series of losses in each month.
If you adapt the 2%-6% rule, then you can allocate 10% per trade, knowing that you don’t risk more than 2% of your account. You can adjust it after each trade, monthly, quarterly, etc. It depends on your risk tolerance. Adjusting monthly seems like a good compromise.
The general idea is knowing in advance how much you risk on any given trade and allocate the capital accordingly. If it is absolutely critical for you not to lose more than 2% per trade, you can set a stop loss of 20% per trade. I personally don’t do it for two reasons. First, many times you have couple of days of theta with flat IV and then IV jumps, reversing the loss. Second, with spreads, your fills are going to be terrible if you place stop loss order, much worse than you could get with limit orders. And third, like I mentioned, the loss is very unlikely to be more than 20% anyway.
Here is another way to look at it. Lets say you have a trade which you keep through earnings and require the stock to move about 5% to realize the maximum profit. If it happened, you would realize a 40-45% gain, depending on your entry price. The trade would be profitable 8 out of 10 last cycles. However, when the stock moves less than expected and doesn’t reach the long strike, the trade is a 100% loser.
In comparison, you can have trades which are sold before earnings, producing an average gain of 10-12%, with very limited risk. It is very rare for those trades to lose more than 7-10%.
So what is better – to make 8 times 40% and to lose 2 times 100% or to make 10 times 10%?
In the first case, your accumulative return is 120% (12% per trade). In the second case, it is “only” 100% (assuming 10% per trade). But here is the catch: those returns don’t account for position sizing. Let’s assume you want to risk 2% of your portfolio per trade. In the first case, you know that you will win most of the time, but when you lose, you can lose 100%. So you can allocate maximum of 2% of your account per trade, which gives you a total portfolio return of 24%. In the second trade, you can rarely lose more than 7-10%.
Now you see the difference? With the second trade, I can have much smaller average returns, but with proper allocation, I’m still way ahead.
Position sizing is especially important in options trading when losses can be substantial.
In my educational forum SteadyOptions we teach all aspects of options trading, inlcuding:
- How to treat options trading like a business and to profit from it.
- How to use the Options Greeks to your advantage.
- How to be your own Risk Master.
- How to manage risk and Position Sizing.
- We will share our trades with you.
Kim Klaiman is an active options trader and founder of SteadyOptions. He trades mostly non-directional strategies, like pre-earnings strangles and iron condors. Likes to trade strategies with negative correlation. He lives in Toronto, Canada.Visit my options education forum http://steadyoptions.com/