Editor's note: Proper position sizing is one of the key tenets to successful investing over the long term. Today, we're sharing an essay from Dr. David "Doc" Eifrig – excerpted from a brand-new special report – in which he explains how to put this idea to work...
Trading intelligently means trading the right position size. It's as simple as that.
For your first options trades, you should trade one single contract until you feel comfortable. It doesn't matter if you've got a trading account the size of Bill Gates'. Just start small.
Of course, when you understand how things work, you'll want to size your position to make sure you keep your capital safe and grow it at the optimal rate.
Trading coach Van K. Tharp runs a test when he's speaking to a crowd. He tells his attendees to imagine they each have $100,000 with which to trade. Then he starts pulling marbles out of a bag. Each marble has the results of a trade. The attendees can invest whatever amount they'd like before each trade. He plays for 50 rounds.
Now, everybody playing this game gets the exact same trades... but they all end up with different amounts of money. He's seen people range from bankrupt to $13 million.
While you think that your success depends on picking trades that go up... your position size (or bankroll management) means even more to your wealth.
You need to come up with some position-sizing rules to keep yourself in the game and making money.
First of all, you shouldn't be using your full retirement savings to trade advanced options. The term "play money" sounds dismissive, but that's what it is. This is a speculative endeavor to boost your returns and earn some money.
How much you invest is an entirely personal question... $10,000 is one person's life savings and another person's blackjack bet. But you should segregate your retirement funds and only trade with money you can afford to lose.
Still, we don't want to lose it. We want our options account to continue to grow over time. And you do that by position sizing intelligently...
If you want to know how much of your options-trading capital you should invest in each trade, the simple answer is 5% to 10%.
We're going to expound on that number so you can think about it intelligently, but that's a starting point if you are not mathematically inclined.
Imagine that you have the ability to choose between a trade with a low probability of winning, but a high rate of return and another trade that had a better probability of winning and a lower return. These strategies can look somewhat similar on an expected-return basis, but the lower probability trades mean you will go bust more often unless you are careful about position sizing.
You need to keep trading long enough to hit your average gains. Consider a strategy that loses money 90% of the time but pays such a huge payout when you win that it's worth pursuing. If you put 50% of your portfolio into each trade, you are likely to go bust before you get a win.
You may think that putting 10% into each trade will fix the problem. That gives you 10 tries to catch a win, and you should expect to win one out of 10. But in reality, you have a great chance of going on runs of 10, 20, even 30 losses in a row.
If you've got a lower probability trade, you have a higher chance of going on runs of losses.
Let's compare two strategies...
- Strategy A: Win probability of 80%, and when you win, you collect 150% of your investment (a 50% return). The "expected return" is 120% of your money, or a 20% return.
- Strategy B: Win probability of 20%, and when you win, you collect 600% of your investment (a 500% return). The "expected return" is again 120% of your money, or a 20% return.
On average, these strategies have the same expected return. But let's simulate these portfolios to see what happens.
We assume that each trader puts 10% of his account into each trade and each trade runs one after the other (not multiple positions at once). Then we simulate each trader 1,000 times.
Both these strategies should make money, but we want to see how likely you are to go bust before you get the chance to go average. We'll take a look at the traders after 10, 50, and 100 trades.
Finally, we define "going bust" as losing half of your account. (Since we invest a percentage of the portfolio, we can't really get to zero.)
When you trade a strategy with an 80% win probability, you have a much higher likelihood of staying in the game and making money – even if the strategies have the same expected return.
We can flip this strategy on its head. Let's say we have a strategy that has a 50% win rate and returns 50% on a winning trade. In this case, let's vary the position size. The aggressive trader bets 20% of his account on each trade and the conservative trader bets 5%.
That's amazing. You've got a strategy that is mathematically a winner. But if you bet too much, you've got a greater than 50% chance of losing most of your money.
Meanwhile, the conservative trader is almost guaranteed to be around after 100 trades and the average trader would turn a $10,000 portfolio into $25,500.
Position sizing is important. And the lower probability your trades, the more you need to think about how much you invest.
Fortunately, given our options trades, you can tune your probability of success and your returns. You can choose to be more aggressive. But if you want to stay in the game, you need to scale down your position size.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Over the past year, Doc and his team have tested a powerful new options strategy. They've quickly generated massive returns on everyday stocks and funds – like 95% in 18 days on sports-apparel giant Under Armour... 181% in 46 days on steel stocks... and even 123% in only 13 days on online-dating company Match Group. Doc just put together a brand-new presentation to explain the details of this strategy. Watch it here.