Risk Management and Position Size


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Hi Mark,

How do you determine position size ? What can someone use to guide
them to determine lot size, contracts traded etc ?

Dave

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Hi Dave,

Obviously, a good question and one that I never addressed.  I'll offer some guidelines and an example.  As you may suspect, this is a guide and not a method for deciding exactly how many contracts to trade.

1a) At the top of the list : The trader must be comfortable with the largest possible loss for each position.  If a position involves being naked short calls, then that 'maximum' must be estimated. 

This is just as true for premium buyers as for premium sellers.  Buyers cannot get wiped out overnight, but they do get wiped out by paying prices that are too high or holding positions too long.

1b) A more realistic reply is that the trader must be able to withstand the largest likely loss.  This is true not only for each position, but it must be true for the entire portfolio (this is the part many traders ignore).  If you have five positions and each passes the test, be certain that if all five were to move against you at the same time that you would survive.

1c) By 'survive' – I do not mean 'barely survive.'  It means that the loss from a single position can be shrugged off as the cost of doing business.  It also means that the drawdown from a total disaster (losing the maximum from all positions at once) does not eliminate your ability to continue trading.  Risk of ruin must not be ignored.

The above response does not answer your question

Here are more General Guidelines.

1) Determine how much money you want to devote to trading options.  If possible open a separate account to house that money.  If you do any covered call writing, then obviously this account must include your stock holdings.

If you keep your entire investing assets in a single account, then it is difficult to see how much margin is tied up with option positions.  When there is extra cash (or margin availability) lying around – it's tempting to use it.  Thus, a separate account (surely your broker will accommodate your request for a sub-account or a separate account) makes it much easier to track option P/L and risk.

2) If you do as suggested, then 100% of that account is devoted to options trading.

3) If you choose to accept portfolio margin (many brokers require 100k minimum for this) you have the room to trade many more contracts and much greater size.

If you choose (or must accept) Reg T margin, then you are more limited.  However, that's not a bad thing because you are ultimately safer.

In my opinion, Reg T margin is best for the vast majority.  If you have proven to yourself that you can handle larger positions, if you trust your risk management skills, then you can opt for portfolio margin – if eligible.  But please know this:  With Reg T margin, positions are limited and you cannot go into deficit. That is not true with portfolio margin.  Obviously your broker will limit risk because if your account goes into deficit, the broker is at risk that the customer will not be able to repay.

4) Never use all available Reg T margin.  Allow at least 15% for emergency needs – such as making adjustments that increase margin.  There's no room to discuss here, but not all risk-reducing trades decrease margin requirements.

5) Dave, if you have a small account, trade small.  With a $10,000 account, you don't want to trade more than three or four credit spreads, or iron condors at one time.  A loss of $2,000 would not put you out of business, but it would be a significant loss.  And it's easy to lose far more than that with a 4-lot, 10-point iron condor.

6) When you begin trading, it's not so easy to recognize an acceptable position size.  Paper trading can be very useful in this regard.  When you experience the profit and loss per spread, you can get a feel for what would be at stake when trading live.

7) Truths

  • Most
    people who begin trading are optimistic.  They do not think in terms of
    losses, but instead, concentrate only on how much money they can earn

  • It's virtually impossible to find a reasonable position size when the trader does not consider scenarios in which money is lost
  • If you accept the premise that limiting risk is essential to becoming a successful trader, then sizing trades is easier.  If neglecting risk, selecting position size is merely a guess


Assume you trade a specific strategy with limited losses.  Further assume that you have the discipline to exit the trade when your loss reaches a certain level.  This loss level does not have to be written in stone, but it's a reasonable approximation. 

If those assumptions are valid, then you can establish an appropriate position size. 

Next, decide the maximum dollar loss per trade. Assume your position goes awry and you
lose 10% above that maximum loss. 

That's it.  That tells you how many spreads you can afford to hold at one time.  Obviously of you find a trade situation that feels better than normal, you can increase size by a modest amount.  When markets are more uncomfortable for you to trade, enter with smaller size.  You can always add to a position later.

Example:

Assume: (Please recognize that approximations are made)

a) You, Dave, prefer to sell credit spreads.  Calls/puts or both (iron condors)

b) Your minimum premium requirement is to collect $1 for a 5-point spread. (20% of the maximum value)

c) Your account is valued at $100,000

d) You plan to carry at least 10 such positions at one time (that's a large number, but let's go there for now)

e) You are psychologically and financially able to accept a loss of $5,000 from any one position

f) You have the discipline to exit a trade (ignore adjustments for this discussion) when the loss is $150 per spread [This is a randomly chosen number; it is NOT a recommendation]

g) You must limit portfolio losses to $20k at all costs.  This is the bottom line for you.[Again, a random number]


Based on those assumptions, what can you trade?

If you trade a 5-lot of each, and if you only collect your minimum of $100 per spread, then you sell 50 spreads (5 x 10 positions) and collect $5,000.  If there are any iron condors in this portfolio, you collect an extra $100 for each of those (you collect on both puts and calls).  The maximum possible loss is $400 per spread, or $20,000.

And that's the worst case.  You plan to exit when losses reach $150 per spread,  If that happened to all 50-lots simultaneously, you would lose 50 x $150, or $7,500.  Allowing for a loss that's 10% above the maximum (poor execution of orders, or delay on your part), moves the loss to $8,200.

If some positions are calls and some are puts, you would not lose that much.  

Thus, it's reasonable to trade about 2.5 x as much, moving the maximum loss to that $20,000 level.  This is a very unlikely outcome and with this scenario, I'd suggest that you could afford to trade as many as 12 to 13-lots of ten different (5-point) credit spreads. 

We all know that that is too many positions to manage effectively,  but you can afford to trade a reasonable number of contracts.

If you trade only one position, you can trade the same 60-lots.  And if selling 10-point spreads at $200, then 30-lots should be okay.  Trading this much size would present no problems as far as margin is concerned. [Margin requirement is 30k, less cash collected, on 30, 10-point spreads).

Dave, this is approximate, but I don't know how to decide how much size is appropriate to trade without going through an exercise such as this.

'This above all, to thine own self be true."  That means – DO NOT move beyond your comfort zone.  Trading less size is just fine.  It's trading more than your  size limit that must be avoided.

722


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3 Responses to Risk Management and Position Size

  1. dave 06/21/2010 at 5:44 PM #

    Thanks Mark !! That was not only and excellent answer but extremely thorough !!

  2. Joe 06/21/2010 at 9:23 PM #

    Mark,
    Great post. I would like to add to the theme by saying that I feel determining position size with a smaller account to be easier than with a larger one, might just be pyschological but thats how I felt when I traded smaller. Now that I trade a 100K account on portfolio margin I feel the purchasing of additional protection (kite, otm put, etc..)when opening my ICs provides me with the comfort to trade larger.

  3. Mark Wolfinger 06/22/2010 at 6:20 AM #

    Joe,
    I like the attitude.
    If you are going to trade much more size – by using portfolio margin – it feels right to sacrifice some potential profits for insurance.