Placing trades is the easiest part of the trading process. Anyone can place a trade. It’s how you manage the trade after you have it on which is key and an indication if you will be successful over the long term.
Think about risk first before you put on a trade, especially sequence risk. The law of large numbers is your base for managing risk. Don’t get emotionally attached to their trades.
Sequence risk is the possibility that a trader could have multiple losses in a row. The best way to attack this is through proper position sizing. Position sizing helps reduced the impact of consecutive losses. The lower the capital risked per trade, the lower the probability that a sequence of losing trades will cause a significant drawdown. This is key.
We know losing trades are going to occur. Accept it – it's just probabilities. So, trades must be managed appropriately. The key is starting with a proper position size.
The most important decision you will make as a successful options trader is how much to allocate per trade. From a risk-management standpoint, maintaining a consistent position size among your trades is of the utmost importance. We want to limit the havoc that one trade could have on our portfolio.
Trade often to apply the Law of Large Numbers/Central Limit Theorem. Because of the Central Limit Theorem, we know how much variability we can expect between our average P&L and the long-term average based on the number of trades we made. The more trades we make, the more likely our average P&L is to be closer to the long-term historical average of all trades. KEY: More trades = less uncertainty.
What is small? It depends on the person and account size. There is the Kelly criterion that helps define the optimal trade size (or betting size at the casino).
When applying this to stock options, for each undefined risk trade, we like using 3 – 7% of net liq (net liquidation value), with an average of 5%. For defined risk, we reduce that to 0.5 – 3%. That’s on a per trade basis. We don’t use any sort of max loss for the most part as we’d rather look to extend duration and manage those losers
I realize the discussion is fairly simplistic. It’s a stepping off point for mechanical money management. Emotions are the enemy. We will be wrong; we will be right. Deal with it with trade size management.
Have a defined stop-loss serves to benefit the performance of our portfolio. We know when to exit a for gain and when to cut losses.
If you want to be a successful trader/investor over the long term, then taking the time to figure out an appropriate position-sizing plan is key.