by Traders Reserve | July 10, 2012 11:37 am
The rally over the past few weeks has occurred at a blistering pace. Only a handful of times in history has the market, namely the S&P 500, pushed lower by 10% or more over the course of one month, only to rally more than 10% in the following month.
In fact, this kind of rally occurred only eight times over the past 60 years. But more importantly, each rally came in the middle of a bear market.
Before May, the first four months of the year were on track to host the S&P 500′s largest gain in over 20 years. Between January and April the index was up 13.7%.
Most investors would think that a historical first four months (especially during a presidential election year) would be advantageous to an options trader. If you are buying calls, then yes, this time frame would likely mean big gains.
But how many professional options traders actually held their respective positions during this entire rally?
I can tell you firsthand: very few. Because the strategy of most professional options traders is some variation of a credit spread, a different beast than straight calls.
Truth be told, the first few months of the year was tough for traders using credit spreads. Even those of us who trade out-of-the-money credit spreads took losses.
I have been asked several times by my subscribers in Options Advantage over the past few weeks how to handle extreme moves in the market. While there are numerous answers, the simplest and most effective is appropriate position-sizing.
Position-sizing refers to the size (dollar amount) of a position within your portfolio. It is imperative that your account size and risk tolerance be taken into account when determining appropriate position-sizing.
Using the beginning of the year example — even IF we use strategies intended to take advantage of huge moves, we can still lose. No trade is a lock. No guaranteed winners exist. So position-sizing is always important.
Every investor has a different risk tolerance, performance goals and account size, so everyone’s position size will be different.
How do you know how much to trade with, then?
There are guidelines that I know will be useful to you if you struggle with the concept of position-sizing.
My favorite guideline is the Kelly Formula.
In probability theory the Kelly criterion/strategy is used to maximize the long-term growth rate of repeated plays of a given trade that has positive expected value.
The formula specifies the percentage of the current bankroll (overall investment funds) to be bet (invested/traded) at each iteration over the like the trading portfolio.
In addition to maximizing the profit, the Kelly strategy also includes the added benefit of having a zero risk of ruin; the formula will never allow for a loss of 100% of the bankroll on any trade. An assumption of the formula is that currency and trades are infinitely divisible, which is actually satisfied for practical purposes if the account size is large enough.
Here is an article that should give you the basics of the position-sizing strategy: How Much Should I Stake – Kelly’s Strategy
Position-sizing is one of the most important aspects of any investment strategy, particularly the trading strategies that we follow. In my opinion, it’s the most critical concept you need to tackle as a trader or investor.
Why is it critical? It is critical because the question of “How much should I allocate” determines your risk and your profit potential.
It’s that simple.
If you want to be a successful trader/investor over the long term, then taking the time to figure out an appropriate position-sizing plan is imperative. Please, please, please do not overlook this important concept.
You will not regret it.
This article was originally written by Andy Crowder
Source URL: http://investorplace.com/2012/07/why-position-sizing-is-critical-to-options-success/
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