We all fear losing money, it’s a natural human emotion. Myself included, I fear losing money just as much as the next person. But today I want to try to walk through a rational and logic sequence of questions that I believe, if follow the series, will help you uncover the only true risk in the market to your portfolio – and more importantly how to avoid blowing up your trading account in the process. I’d even dare to say that if you follow my 4 question logic sequence in the beginning of this show, you cannot help but come to the same conclusion about trading options including why the “staying alive” framework all but ensures you’ll find success in any market.
Q: Do you agree that we cannot make only one trade and be successful?
If you agree, then the next logical question is:
Q: Do you agree that making only two trades won’t work either?
If you agree, the next question:
Q: Do agree that many trades work better than fewer small trades?
- Everything can be mitigated, except for sequencing risk.
- Sequencing risk is the risk that you run in any system.
- It is the risk that you will run into a string of bad trades where you have no control over the outcome.
1. Trade Size
- If you are allocating 10% of your position to every trade, and you allocate a full portfolio 10% to every ticker, then you are effectively giving yourself an opportunity to completely blow up your account, given one bad swoop of trades.
- If you randomly pick 10 tickers, allocating 10% for each ticker and in a really bad sequence of returns, you could end up seeing those 10 trades completely wipe out your account.
- What we suggest at Option Alpha is keeping your trades size under 5%, because if you have a small account, you might have to push that 5% threshold just to get the trade on. But if you’ve got a large account, you should be at 1-2% for every trade or less.
- If you get a string of 10, 20, or 30 of them in a row then you will definitely feel it, but you will not be knocked out.
- If you agree that trade size can definitely help, the next logical sequence is balance.
- Using options gives us the wonderful opportunity to trade both sides of the market; having bullish, bearish, and neutral positions.
- That way, if the market makes a wild, ridiculous move in one direction, it only affects half the portfolio.
- Having trades on both sides allows you to potentially reduce the impact of a major sequence of trades that move your positions lower to the downside.
- This will not absolutely overcome the move in the market, but it will keep you alive to keep trading for another day.
3. Diversity of Tickers
- The idea is that if you understand trade count and you understand that you have to be balanced, then it makes to have a diversity of tickers with uncorrelated risk.
- This means having trades on both sides of the market in a lot of different industries and sectors.
- If you get around 10-15 tickers (on the high end) you’ll probably get as much diversification as you need to be successful.
- As you really diversify the number of stocks that you are trading, you get less and less of a benefit to doing that.
- In options, because you can choose sectors very easily, then you can complete that diversification pretty quickly in 10-15 different tickers.
- There is no set rule on which tickers to choose; select the major markets ETFs, including bonds, emerging markets or currency, a metal or commodity.
- The idea is to try and hit some of the major groups, and then fill in the gaps with tickers that are really popular at the moment with high IV.
4. Trade Count
- There is no magic threshold to cross when it comes to trade count.
- We have no way of knowing what you sequence of trades is going to be.
- Even at 100 trades, you still have some variance.
- It’s not until you start getting up to 500-1,000 or even 1,000-2,000 trades that you start really solidifying your system and your probabilities and your expected outcomes.
- You could have a series of 20 trades that go against you, but they get averaged out through 1,000 trades.
- The only thing that really breaks the sequence of returns is trade count.
- Traders who stay in the game the longest end up being the most successful.
- Stay alive, never letting one bad movement knock you out!
— The Option Specialist