Options Theory: Size Matters
December 4, 2020
You place four trades – three small, one big. You profit on three of them and are able to boast a 75% win rate. That’s good by any measure. Unfortunately, you didn’t make any money. Why? Well, because you won on the three small ones while losing on the single big one.
Such is the danger of inconsistent sizing. Varying the risk amount in each trade invites randomness to come to play. And he’s a nasty fella with a reputation of giving traders small gains while making them eat large losses.
It’s a recipe for meager returns at best and disaster at worst.
Call Me Cleo
One of the things I love about the Tackle Trading Journal is it tracks several key performance stats. Show me your win rate, average gain, and average loss, and I’ll tell you whether profits lie in your future.
Is it because I’m a fortune-teller schooled in the dark arts of divination? Nope. It’s because I know math.
No matter what your trading systems, the formula for profits is simple. The sum of your winners has to be larger than the sum of your losers.
- If sum of winners > sum of losers then you’re profitable.
- If sum of winners < sum of lowers then you’re not profitable.
There are three things you can do to increase your likelihood of success.
- First, increase your win rate. For instance, start winning 7 out of 10 trades instead of only 5 out of 10. This one is really hard, if not impossible. At a certain point, no matter your skill level, your improvement path will reach a plateau. All patterns fail, all traders suffer losers. Period.
- Second, increase your average gain. Even incremental increases can have a big impact. Maybe your average winner rises from $75 per trade to $85.
- Third, decrease your average loss.
Here’s an example of an account with over 300 trades in the sample. These were swing and position trades using options where I picked different symbols and strategies over time.
Note the key trade metrics up top.
- Win Rate (aka percent profitable): 61%
- Average Winning Trade: $70.29
- Average Losing Trade: -$74.44
Keep in mind the ideal numbers vary depending on strategy. The majority of these options trades were high probability plays like naked puts and credit spreads which typically have an average loss that is 2x to even 3x the typical gain. With strategies like these, it’s impossible to get your average gain higher than your average loss.
In contrast, a stock trader should definitely shoot for having an average win far larger than their average loss. At the same time, the win rate would be lower.
If you haven’t created rules to ensure you’re consistent in the dollars risked for each position, then I highly recommend you do so.
Exceptions to the Rule
Let me conclude with a few scenarios where I could see someone deviating from this.
- First, if you are more comfortable or have a better track record with certain types of trades, then you might decide to risk a little more in them. I’m fine with that.
- Second, you might have some longer-term core positions such as long stock or covered calls, that require you to take more risk to avoid getting stopped out too quickly. I’m okay with that too.
I would just make sure the same types of trades have similar risk. My short-term swing trades all risk the same. My speculative debit or credit spreads all risk the same. My day trades all risk the same. You get the idea.
Tackle Trading Resources on Journaling
Continue learning about this powerful trading tool: the Trade Journals. Tackle Trading has all the resources you need to MASTER them like a PRO. From the Trade Journals themselves to free articles and tutorial videos on how to make the most out of them, we got you covered!
Trade Journaling for Beginners [Free Articles]
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Read more Options Theory [FREE Content]
Every Thursday our resident options addict, Tyler Craig, will be at the helm to help you demystify derivatives and better understand what truly makes them tick. Options for beginners? Come this way, please. Enlightenment awaits.
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