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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