You’ve found the perfect options setup, but how many contracts should you buy? One? Ten? One hundred? This seemingly simple question can make or break your trading career. Or have you ever wondered why two traders can execute the same winning options strategy, but one ends up rich while the other goes broke? The answer to these questions often lies in position sizing.
Position sizing is a crucial practice for options trading if they want to maximize their potential profits or minimize their potential losses in a manageable manner. Position sizing is a risk management technique where traders determine how many options contracts to buy or sell with a single trade. It specifies the number of units invested in a certain asset or security like options, stocks, bonds, or currencies. Position sizing is a key component of a comprehensive risk management plan.
In this blog post, we’ll delve into the art and science of position sizing, providing you with practical methods to calculate the optimal number of contracts for your trades, helping you to protect your capital, and maximizing your potential returns.
Why Position Sizing Is Crucial in Options Trading
Position size is one of the more important elements of successfully trading options online, but it’s severely overlooked by those who aren’t super familiar with options or don’t have the experience to know better. It’s a key aspect of risk management that ultimately determines how much of a specific asset you’re going to buy or sell per trade.
Why does position size matter when it comes to trading options online? What’s the point of it? We will discuss the main goals of using correct position sizing when trading assets like options, stocks, bonds, or currencies like crypto. It’s one of the most subtle forms of risk management that cannot be missed and could cost you dearly if not implemented in the right manner.
Capital Preservation
Proper position sizing prevents catastrophic losses that can wipe out an account. Think about the idea of “putting all of your eggs in one basket.” You could lose everything you have if you put it in one place. The same principle applies to online options trading—you only want to use a small portion of your money to reach a position you maintain to ensure you don’t get financially ruined if the market moves against you.
Let’s look at a hypothetical example. Imagine risking 50% of your account on a single trade. A losing trade could cripple your ability to recover because you stand to lose half of the capital you have invested in the market. It’s highly recommended that traders only dedicate 1-2% of their total money to a single trade to mitigate against potential losses.
Consistency and Long-Term Profitability
Online options trading is much less about chasing big payouts on winning trades and much more about playing the long game of trading consistently and seeking long-term profits. Consistent, smaller wins achieved through proper position sizing are more sustainable than sporadic, large wins followed by large losses. It’s a slow, steady approach that’s used by many professional investors to build their wealth over the course of years and months.
“Slow and steady wins the race” is a good analogy to use to get the point across with this principle. Correct position sizing keeps the scope of each trade small, but it keeps losses to a minimum while also offering the potential for growth over time with enough of these smaller moves.
Psychological Benefits
Proper position sizing comes with one of the most significant benefits of reducing stress and emotional decision-making. When your money is well managed and under control, it’s much easier to maintain a healthy mindset and not worry about losing too much money. Position sizing keeps your losses under control, and they can encourage traders by showing slow, steady growth over time.
Knowing your maximum potential loss on any given trade allows you to trade with a clearer mind and avoid impulsive decisions. As long as you keep with your trading plan, you can move forward with confidence, having a clear roadmap of where your money is going and what your best- and worst-case scenarios could be. You can maneuver the options market (or other tradeable assets) with a good idea of what’s at risk and where you could pull ahead, all based on simple math. It’s similar to the mental benefits that come from working on a budget for daily living.
Avoiding Overtrading
A well-defined position sizing strategy prevents overtrading, a common mistake among novice traders. Overtrading is the act of buying and selling too much, which happens frequently with traders who stake too much money on any given trade they’ve added to their portfolio. This can even occur to brokers, where they overtrade to earn more commission from their investors. Correct position sizing can help individual traders/investors and brokers alike avoid taking on more trading action than they can handle from a budgetary standpoint.
Now that we understand why position sizing is so important, let’s explore some practical methods to determine your optimal position size.
Factors to Consider Before Determining Position Size
Before determining your position size, there are several factors that you should take into consideration. A few of these include your account size (available capital), your personal risk tolerance, and the amount of risk tied in with each trade. Read up on these factors to get a blueprint of how to inform the position size for your next trade.
Account Size
Position size should be proportional to your total trading capital and the best way to know that you’re correctly managing your money is to use the “1% Rule.” This refers to allotting only 1% of your total capital (2% at the very most) to any single position in your portfolio.
The amount allotted to each position will look different between different traders. A $10,000 account should trade smaller positions than a $100,000 account. Traders with more capital will have a larger 1% compared to traders who have less money to work with. A trader with $100,000 will want to use a position size of $1,000, while a trader with $10,000 will use a position size of $100.
Risk Tolerance
An understanding of your comfort level with risk is another of the key elements of informing the position size for your next trade. While it’s generally recommended to use only 1% of your total available capital for each position, you can always take a more aggressive or a more conservative approach. Those who are willing to be more aggressive in their pursuits of profit might use a position size of 2%, while someone who is more risk-averse might use a position size of only 0.5% on their trade.
These conservative or aggressive risk profiles all depend on how investors feel about risk. Some people are not willing to put up any more than a certain amount of capital (for good or bad reasons) on their trades, but others see the opportunity of using more risk to lock in a largely potential profit.
If you’re uncertain of where your risk tolerance might lie, we’d suggest asking the following questions to get a gauge for this element of determining your position size:
– How much of your account are you willing to lose on a single trade?
– How much drawdown can you tolerate before it affects you emotionally?
Trade-Specific Risk
It’s also key to know that different trades carry different levels of risk, even with the same underlying asset. Traders and investors must look into factors like implied volatility, time to expiration, and the chosen strategy with each position they’re looking to take on. What this ultimately means is that some traders have a higher potential for significant losses compared to others. Higher potential returns are often associated with higher levels of risk.
Winning Probability
Higher probability trades may warrant larger position sizes, so traders might have to deviate from their position sizing. However, this all comes down to each trader’s openness to risking more capital to get ahead. You must weigh for yourself if the better probability trade is worth the increased financial risk. Some would say it’s worth it because you have much better odds of succeeding, but some conservative traders might say it’s risking unnecessary money for only a little more in profit.
With these factors in mind, let’s dive into specific position sizing methods.
Position Sizing Methods
To allocate capital in an efficient way and to manage financial risks competently, traders must use well-known and effective position sizing strategies. Using these techniques will help traders learn the rules of balancing their portfolios and find ways to preserve their capital no matter what the current market dynamics are like. Correct position sizing is also an important tool in maximizing potential profits and minimizing potential losses.
1. Fixed Percentage Method
This position sizing technique means that the trader or investor risks a consistent percentage of their total account on each trade. It’s a more standardized approach to risk management, and it’s the recommended method we’ve mentioned already in this blog post. Traders should use only 1% of their total capital on each position. However, traders can adjust this percentage based on their tolerance to risk. For instance, instead of allocating 1%, more aggressive investors can allocate 2% for each position. It all comes down to how much capital the trader has to work with and how much they’re willing to risk to potentially get ahead.
Let’s say you have a $50,000 account, and you risk 2% per trade. This means that you’re putting up a $1,000 risk per trade, instead of the recommended 1%. It’s a more aggressive approach because you’re doubling what you should be allocating to each position ($500). The investors stand to lose $1,000, or they can double their potential earnings.
Pros
- Simple: It’s easy to figure out how much to allocate to each position based on a percentage and the simple math involved with figuring out this position size.
- Easy to Implement: While the percentage remains fixed, the dollar amount risked on each trade will fluctuate based on the size of your total portfolio balance. As your portfolio grows, the dollar amount of your position size will go up and vice versa with portfolio losses. It’s an easy and flexible way to implement your trades.
- Keeps Losses Controlled: Using the fixed percentage model helps traders keep their potential losses to a minimum by using a small percentage of their total capital.
Cons
- It Could Be Too Conservative an Approach: If the percentage that’s allocated to each trade is too low, it can be too safe an approach for investors who have a taste for higher-risk scenarios. It can lead to limited profits in situations where more money could have been made based on strong trade convictions that advanced traders might have.
- Lacks Flexibility: Because the trader is using the same percentage of capital per trade regardless of the market conditions.
Example Calculation
With a $1,000 risk and a stop-loss planned at $2.00 per contract, the trader can buy 5 contracts. ($1,000 / $200 = 5).
2. Fixed Dollar Amount Method
The fixed dollar amount technique for position sizing is where a trader allocates a predetermined dollar amount to each trade. This size doesn’t take into account any kind of growth or contraction of the investor’s available trading capital. For instance, it doesn’t matter if you have an account balance of $10,000 or $100,000 when you set up a fixed dollar amount of $500 per trade. The investors will stake $500 on each position no matter where their current capital balance would be.
Pros
- Simple: When it comes to the fixed dollar method, investors don’t have to calculate a percentage based on their current balance. The fixed number remains constant, making it super easy for the investor to remember how much to stake on each trade.
- Easy to Track: Because you’re not dealing with a shifting percentage stake for each trade, investors can more easily recall and calculate how much capital was allocated to each position using the fixed dollar method.
Cons
- Doesn’t Account for Growth or Shrinkage: Unlike the fixed percentage technique for position sizing, the fixed dollar strategy doesn’t keep the size of your positions proportionate to your overall capital. Unless you adjust the fixed dollar amount up and down with your fluctuating account balance, you could be placing trades that are either eating through too much or too little capital resulting in unnecessary losses or severe missed opportunities.
- Too Aggressive For Small Accounts: Unless you’re using a fixed dollar amount that’s somewhere near 1% of your total capital, the fixed dollar strategy could be too aggressive for smaller accounts where there’s less room for error. Using the fixed dollar technique without a clear plan that hedges the account against losing trades, it’s not a great method for smaller accounts to use.
Example Calculation
With a $1000 risk on each trader, you buy a stock that is currently trading at $25 per share. You would determine the position size by following this calculation: $100 / $25 = 4 shares.
3. Kelly Criterion (More Advanced)
The Kelly Criterion is a mathematical formula that determines the optimal bet size based on the probability of winning and the win/loss ratio. It ultimately helps investors determine how much money they should dedicate to each position in their portfolio. Kelly Criterion aims to maximize the long-term growth rate through the ideal position size for each trade.
It’s key to note that the Kelly Criterion is much better for advanced, experienced traders to use compared to options trading novices and newcomers with smaller accounts. However, Kelly Criterion is seen as far too aggressive for some advanced options traders, which shows that it’s a strategy with a high degree of difficulty (we’ll address more of this in the cons section).
Formula
Kelly % = W – [(1 – W) / R]
- W = Winning Probability
- R = Win/loss ratio
Kelly Criterion helps investors estimate probabilities using their market analysis and trading strategies as a starting point. By inputting the potential profit and loss into the Kelly Criterion formula to get the recommended portion of the capital they allocate to each trade.
Pros
- Maximized Long-Term Growth: This is a hypothetical pro of using the Kelly Criterion because it calculates the optimum size position size that can lead to the optimum long-term growth.
Cons
- Complex to Calculate: When the Kelly Criterion is done manually, it can be difficult to calculate the for options traders due to requiring accurate estimation of winning payoffs and probabilities. It’s more intricate compared to other position sizing strategies due to using an intricate formula that uses several variables.
- Accurate Estimates of Winning Probabilities Needed: Obtaining precise probabilities can be difficult. When probabilities are misestimated, it can lead to the suboptimal position size, which could lead to reduced performance with the Kelly Criterion strategy.
- Aggressive Position Sizes Can Be Recommended: Using the Kelly Criterion can result in some position sizes that might not be the best fit for investors who have limited capital. You could get a position size recommendation that might eat through a ton of your available capital that could put you at significant risk. It’s a better option for traders with more resources at their command.
If the Kelly Criterion is too aggressive of a position sizing technique for you, you have the choice of using the “Half-Kelly” or the “Quarter-Kelly” where you can keep your potential risks at a lower level. With the Half-Kelly option, the investor is still using the Kelly Criterion methodology but taking the final number and multiplying it by 50%. The Quarter Kelly’s final number is multiplied by 25%.
4. Volatility-Based Position Sizing (Advanced)
This position sizing strategy is where the position size is adjusted based on the current volatility level of the market. Investors using this technique will take smaller positions when market volatility is up and larger positions when market volatility is down. Volatility-based position sizing lets investors manage risk more effectively by adapting their exposure to market conditions, based on the volatility of the underlying asset or the specific options strategy.
Example
What volatility-based position sizing comes down to is smaller positions for high-volatility trades and larger positions for low-volatility trades. An important indicator to use is the Average True Range. The higher the ATR level, the fewer shares that traders will want to buy compared to stocks with lower ATR. For instance, a trader will want to use a smaller position size on a stock with an ATR level of $5 versus a stock with an ATR level of $2.
Pros
- More Dynamic and Adaptable: Because investors are taking the current market conditions into account using the volatility-based position sizing, it’s a more adaptable form of position sizing where investors can use the optimum size that’s realistic to the real-world market conditions.
Cons
- Requires a Deeper Understanding of Volatility: Because this is a more advanced position sizing strategy, it can be more difficult to execute correctly due to the experience needed on the investor’s part to read the market and anticipate where it’s going.
- Impact on Option Prices: Volatility position sizing indirectly impacts the volume of buying or selling activity in a market. Higher volatility leads to smaller position sizes which results in small price swings and less market pressure, while lower volatility does the opposite. More people using this method can impact the market in ways that some investors might not be expecting.
Choosing the right method depends on your circumstances and trading style. Experiment and find what works best for you. If you’re newer to investing or online option trading, we’d recommend using the fixed percentage or the fixed dollar position-sizing technique. Even advanced traders should take care when using Kelly Criterion or the volatility-based position sizing techniques—start small and then work your way up if you’re in doubt.
Practical Tips and Considerations
What are some good practices for traders to get into when determining what your position size should be with each trade? Look no further than some practical tips and considerations that new and experienced traders should keep in mind when allotting capital to each position.
- Start Small: Especially for beginners, err on the side of caution because you’re not familiar with options trading to begin with and beginners tend to have less capital to work with meaning that there’s a much smaller margin for error. Starting small can happen when using the fixed percentage strategy, and the fixed dollar technique to an extent (as long as you keep the fixed dollar amount low and adjust it up and down with capital growth or contraction).
- Adjust as Your Account Grows: Periodically review and adjust your position sizing as your account balance changes. Using the fixed percentage strategy, you don’t have to worry about this as much because you multiply your account balance by the 1% or 2% you’re using as your position size. This applies much more to the fixed dollar technique.
- Consider Maximum Position Size: Set an upper limit on the number of contracts you’ll trade, regardless of the method used. This is common sense if you’re thinking about the worst-case scenario unfolding and looking to limit potential losses. While there’s a place for risking a bit more to possibly reap some extra profit, there should be an upper limit to keep you insulated from a crippling loss.
- Diversification: Don’t put all your eggs in one basket. Diversify across different underlying and strategies. If your money is tied up in one or two investments, on top of your position size being too high, you possibly lose everything you have in investments. It’s best to use a position size of 1% and have the money spread over multiple sectors and industries.
- Keep a Trading Journal: Record your position sizes, the rationale behind them, and the trade outcomes to refine your approach over time. We had mentioned earlier when talking about Kelly Criterion that it’s important to have accurate estimates of winning probabilities to succeed with the strategy—a trading journal could help tremendously in this regard.
- Don’t Forget Transaction Costs: Factor in commissions and fees when calculating your position size. These can impact small accounts more as there’s less of a money cushion. By not working these numbers into your profit estimates, you might not bring in the money you were expecting.
Implementing these tips will help you stay disciplined and consistent in your approach to position sizing.
Find Out Which Position Sizing Method Works For Your Trading Plan
Whether you’re looking to maximize your profit potential or your main concern is minimizing potential losses, correct and efficient position sizing techniques are needed to determine the number of units invested in a certain asset or security. It’s one of the cornerstones of forming a comprehensive risk management plan.
Before choosing a position sizing technique, it’s best to account for the factors that would work best for your trading plan like the size of your account, how open or closed off you are to making risky moves, or examining the risks that are specific with the trades you want to make.
Newcomers and intermediate investors can benefit greatly from using the fixed-percentage or fixed-dollar position sizing techniques to find out the best amount of capital to dedicate to each trade. If you’re feeling more ambitious and want to capture the ideal position size by taking the market nuances into account, check out Kelly Criterion or volatility-based techniques.
We’d encourage all our readers to implement these strategies in their trading. Mastering position sizing is not just about maximizing profits; it’s about surviving the inevitable ups and downs of the market and achieving long-term success in your options trading journey.
