Limiting Undefined Risk Trades
Option strategies with undefined risk like strangles and straddles must be limited based on account size because of the capital requirements they carry. I'll show you why if you're trading a smaller account you'll want to avoid these types of strategies even though they generally produce the greatest profits. Remember that your goal as a trader is never to blow up your account and lose all your money. So, trading risk defined strategies at this stage is still a very profitable way to grow your account.
In this video tutorial, I want to talk about limiting your naked or undefined risk trades. Remember, undefined risk or naked option trades are in fact really risky and need to be managed according to your account size and your trading style and your experience.
The first thing before we get into this. I don't want you to think that you shouldn't make these trades because you absolutely should. In fact, they offer the highest probability of profit and dollar return out of any strategy that we usually choose.
Of course, for all of this, you do have to put up more capital for each trades, so there are a give and a take. You have a higher probability of success; you potentially could make more in absolute or total dollars.
Then the market is going to compensate for that by requiring that you put up more capital and this is why these trades are a little bit more capital intensive.
They’re geared towards accounts that are a little bit larger in size that can handle the margin fluctuations that happen. That said, you don't want to over leverage these trades, and I think that's really what I’m trying to get to here in this video.
We look to keep the number of trades small as well as the size of the trades in our account. Our suggestion going forward with limiting the number of naked trades is to keep your overall margin limited to just 5% to 10% of your account with under 10 trades at any one time.
I think that’s just a good rule of thumb to use, is that you keep your initial margin requirement limited to 5% to 10% of your account balance.
You’ll notice that we have an asterisk next to initial margin because we know that margin can expand in these positions and that that initial margin is just what the broker requires to collect upfront in the position.
If the trade starts to go against you, then margin can sometimes expand up to 50% of the original initial margin requirement, it can jump by another 50%.
That's why we suggest that you start small with these because as you get started in them, you may not understand just how much margin can expand and take up more of your account size.
People who are getting in this business, who have been in this business a while and traded these too large and then saw implied volatility expand and their accounts blew up because of that, that's why you need to keep these small.
About the number of trades, we say less than 10 because they are high-risk trades and they needed to be managed more aggressively.
Unlike your risk defined trades like credit spreads and iron condors which you can let on until expiration and leave them be, you don’t have to do a lot of management with those, with these types of trades, you have to be a little bit more active with your adjustments and management.
So we suggest that you keep at least less than 10 in your account at any one time just so that you have something to continuously look over and you’re not going to miss one of these trades because you have too many of them that you're reviewing and monitoring.
As always, I hope you guys enjoy this video. It’s just a quick video. Hopefully, it drives home the point about just limiting the number of trades in your account and makes you a little bit more aware.
As always, if you have any comments or questions, please add them right below this video on the lesson page. Until next time, happy trading!
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