Money Management

Here is a good, basic definition of the term ‘money management’ from Wikipedia:

Money management deals with the question of how much risk a decision maker should take in situations where uncertainty is present.

More precisely what percentage or what part of the decision maker's wealth should be put at risk in order to maximize the decision maker's potential.

Money management is a necessity for gamblers and traders. A good understanding of money management minimizes the Risk of Ruin, or the possibility of losing your entire trading account.

The two keys to successful money management are maximizing wins and minimizing losses.
Thus, the takeaway for us, as option traders is:

  • Trade size is a very important decision (how much to place at risk)
  • Minimizing losses is essential (do not stubbornly allow losses to grow)

  • Maximizing gains is a big part of the game (but do not ignore risk when seeking that maximum)

This last part – about maximizing gains for every winning trade – presents the trader with difficult decisions. To maximize profits, you must milk the trade for every last penny. But that's in direct contradiction with the concept of not owning positions when there is very little to gain and risk is large (very poor risk/reward ratio).

Assume a position with limited profit potential has worked well. Perhaps you sold a call or put spread and collected $1.50. When you earn $1.40 and can repurchase that spread by paying $0.10, you come face to face with good money management and careful risk management may appear to be in conflict.

When managing risk, both potential loss and the probability of incurring any loss must be taken into consideration.  When deciding whether to exit a wining trade with limited potential profit, can you afford to take the risk associated with going after the last $10? 
Obviously time to expiration and how far OTM the options are must be considered. However, I’m from the conservative school that believes it cannot be a sound policy to hold this position in an attempt to earn another $5 or $10 per spread.  The risk manager and money manager must come to an agreement.

The idea of trying to maximize profits may lead you to assume that it's always correct to seek that last nickel and allow all short options to expire worthless. That's not a valid assumption.

The term 'maximize profits' does not tell you to ignore risk. It refers to the concept of seeking additional profits from good positions – and that's a position is worth holding. Often risk is too large, reward is too small, and the best decision is to exit.

The definition of money management does leave room for debate on this point.
If you believe that being too cautious is unwise, and if your comfort zone allows trying to capture additional profits, I cannot argue. The borders of your individual comfort zone are yours to define. My task is to encourage you to define that zone and to recognize that it is not a lifetime commitment. Borders can and will shift over time.

I'll continue to pay a small price to exit the trade. Peace of mind has psychological value, and I'm willing to pay a small insurance premium to gain that tranquility.


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13 Responses to Money Management

  1. amit 07/08/2010 at 1:27 PM #

    I was most recently in a situation where I could have taken 70% of profits in a credit spread in 2 days. I delayed. Today at the open for a brief moment it was in loss, I will just wait for coming July expiry to book profits.
    I have also been in situations where the timing was horrible, and I waited out the losses, as soon as it turned into a small gain due to time decay, I closed it out. Now uncomfortable holding high beta stocks.
    Started small and can’t afford to make mistakes.

  2. Mark Wolfinger 07/08/2010 at 2:15 PM #

    I don’t think it serves any purpose to look at a specific example and do a ‘woulda coulda shoulda.’
    To me, it’s not a question of whether one should always take a 70% profit. That’s a personal comfort zone decision. The relevant profit is when the 70% profit was available, was it attractive to continue to hold the position? Nothing else matters.
    We cannot choose ‘hold until expiration every time – no matter what happens.’
    But we can choose to hold until expiration if that seems reasonable. That is the path to seeking maximum gains from a trade.
    My preference is to ‘never hold until expiration.’ That’s my way to keep risk in mind at all times – especially when everything looks rosy.
    The fact that the winning decision would have been to exit does not make it the correct decision.
    If the risk/reward was favorable, if the underlying was well priced, if you felt comfortable with the inherent position risk – then there was nothing wrong with holding. The goal is to manage both risk and money.
    One other solution is to scale out of a trade.
    Trading high beta stocks is not for everyone. If not comfortable, that should be the only point that matters.

  3. amit 07/08/2010 at 2:59 PM #

    Thanks a bunch for responding.
    It looked attractive because I want to reduce my commissions, and there is strong possibility of getting 100% by having it expire.
    Re your advice of scaling out: I will try to keep adjustment of positions to a minimum, so waiting now for expiry.
    But your advice is solid. In a previous life, I spent boatloads on commissions. In this life, I try to minimize commissions and minimize risk in the hope of going further.

  4. Mark Wolfinger 07/08/2010 at 3:08 PM #

    Starting small is good.
    Understanding that it’s important to avoid ‘mistakes’ (I assume you define that as losing money – and for now I will let that go without quibbling) is a crucial part of the path to becoming a winning trader.
    Advice: If you allow trade decisions to be influenced by commissions I can promise you two things:
    1) You are going to have a very difficult time making money. You will allow some small fee to encourage you to take large risk. This is just not a good idea.
    I understand that when trading one- or 2-lots, commissions can be significant, and that scaling is impossible.
    2) You are using the wrong broker. Commissions are very cheap these days.

  5. amit 07/08/2010 at 3:37 PM #

    I understand the part about the tail not wagging the dog, instead of dog wagging his tail. But risk is still small so sticking to one of current trades. I will always try to do less than 10 contracts per trade, to keep risk small. Chose different months on separate trades to try and get a feel for the greeks.
    What do you define as cheap commissions, TK? I can’t use IB, so use OX. Will use IB when I qualify next year. Chose OX because they are closest to IB in their offerings.

  6. Mark Wolfinger 07/08/2010 at 4:06 PM #

    ‘Small risk’ (IMHO) is defined by how large it is compared with the size of your portfolio, and not the size in total dollars.
    A 10-lot iron condor is a gigantic position with huge risk for an account valued at 10k, but is insignificant to a one million dollar account.
    I don’t want to get into names, but some brokers charge extra for valuable items. For example OX has great risk management software. But for me, that software is far more than I need. The point is don’t pay extra for things you don’t need.
    I like TK, and as you know I have a relationship with them. If you do consider going there, let me know and you can get a free subscription to Expiring Monthly.
    It’s not always about dollars when it comes to commissions. But it is about not wasting dollars. My bottom line is that I would hate to take the risk of not covering a short position just to save the commissions. But, paying those commissions does increase trading costs. I know where you are coming from. I traded options (1975) when commissions were MUCH higher.

  7. Jason 07/08/2010 at 7:56 PM #

    I see a lot of chatter on boards for the most part concerning short sided neutral plays but dont come across nearly as much on directional type trading. In theory, I understand because this is often considered a “riskier” play.
    I have found I have the best success trading on 4 -5 stocks (and 2 indexes) over and over again as I seem to learn their movements and ranges pretty well.
    The stocks specifically have medium to low IV and trade pretty decently within a range for the most part which helps me identify a bit easier when they are outside their top and bottom levels and probably due for a reversal of some sort at some time.
    Based on this I have been paper trading some long plays thru slightly OTM calls or puts when hitting a high or low level which has turned out quite well over the last few months. Much better return than my short sided plays. I’m going to take 10% of capital and start placing real funds in the game.
    My question is this. Im sure you’ve had much experience on the buying side. Any particular recommendations you may have on this strategy? Better to be ATM, OTM, etc? (Im using slightly OTM as in 1 strike away) How many months out have you found best? (Im going 2 months out currently). Any particular technical indicators or other analysis tools you find to be helpful? (I currently am just basing when price swings outside the normal range).
    Not really sure exactly what questions Im wanting to ask but more or less get your “been there done that” feedback as to what has worked for you in the past. Thanks

  8. Burt 07/08/2010 at 8:13 PM #

    Great post as always. I’ve noticed that in the past, as here, you’ve cautioned that milking a trade for the last ten cents is poor risk management, which makes sense. But that decision seems relatively easy to make at least in theory if not in practice. What about the trade that is halfway there: say having gained 50% of the total possible profit for a credit spread? It would seem to me that this is where the real test of risk management lies and also the most difficult decision to make in terms of closing or holding because this seems to be where the most uncertainty occurs. How do you handle that decision? Thanks.

  9. Mark Wolfinger 07/08/2010 at 8:34 PM #

    You see most comments about premium selling because most traders understand that is the more profitable side over the longer term – IF, AND ONLY IF, ONE EXERCISES PRUDENT RISK MANAGEMENT.
    To your question:
    I have almost never bought options as a directional play, and I’ve been trading options since 1975.
    A much more detailed reply is scheduled for tomorrow morning (7/9/2010) as a blog post

  10. Mark Wolfinger 07/08/2010 at 8:47 PM #

    Good question. I’ll repost this reply on Saturday so more readers can see it.
    Here’s how I handle this situation. I do not go through each of these steps becasue I have done it enough times. However this is my thought process.
    1) I do not care how much profit has been earned so far on this (or any) trade.
    I know that this statement causes some readers to either believe I am not telling the truth or that I am an idiot.
    2) I look at the position I own right now. I pretend that I can exit the trade at this price – paying zero commission.
    3) Then I decide: Do I want to re-open this trade – at the same price, and again for zero commission? Or am I happy to be out of the trade? I consider the price, the date, the price of the underlying…You get it. It’s a new trade. Do I want it or another trade in its place?
    4) It really is that simple. If I want to own it – I continue to hold and do not exit.
    If I am happy to be out, then I enter an order to exit the trade at my price.
    If undecided, I cover a portion. How much I decide to hold depends on the reason for my indecision. This rarely happens. I find it easy to decide if I want the position in my portfolio. That comes with experience.
    5) Burt – this is why I consider ‘do nothing’ to be an active trade decision. Sure, everyone knows buy is an active decision. So is sell or adjust. But doing nothing is not an act of boredom or disinterest. It’s an active decision to HOLD.

  11. amit 07/08/2010 at 10:14 PM #

    That is where my hangup was. I had a 70% profit and I wouldn’t have entered that trade right there because I knew it was due for a turn.
    Burt: a big thanks for asking that question to Mark, helped me out in thinking for my next time.
    Jason: if you want to buy, buy deep ITM and more than 3 months. Less than 2 months is a no-no. Also use limit order, if you don’t get a fill, leave it, but stay disciplined for a good fill, slippage due to wide spreads kills you. A theta of 0.03 or less (that is option decays only 3 cents a calendar day). I would only buy if I expect a massive move for booking profit.

  12. Mark Wolfinger 07/08/2010 at 10:44 PM #

    Thanks for sharing.
    If theta is that low, I don’t see anything wrong with one- or 2-month options.
    Deep ITM options have lots of market risk when prediction is very wrong. I don’t mind (theoretically) paying a bit more time decay for the added safety.
    Glad you had a light bulb moment.

  13. Burt 07/09/2010 at 8:47 AM #

    Mark, Thanks for the comprehensive response.