In this video, we’re going to talk about small account option strategies and basically, how you can use the money that you have in a smaller trading account to make the most of your options trading activities.
At Option Alpha, we basically, define small accounts as portfolios with less than generally $25,000 of equity or cash available for trading. Now, this is still a lot of money, and we get that.
These strategies we’ll be talking about have nothing to do necessarily with size, but just with controlling risk so that you have the best possibility of making money long term with your account until you either put more money in or start making more money trading.
Because I realize that this entire options game is based on probabilities and math, I have always 100% been a huge supporter of small position sizes regardless of the total value of the account. This is key. We’ll go over it here a little bit in more detail.
Now, as a small-account trader, you should be focusing on the following things, and we’ll cover each of these bullet points as we go through this part of the training process. Number one, you should be focusing on small allocations for each trade.
I have an asterisk there because we start talking about that a little bit more next. Number two is you should focus on risk-defined strategies, never naked positions or undefined-risk strategies.
Number three is high-probability, highest-IV trades first. You want to grab that low-hanging fruit, the trades that have the biggest theoretical edge. That’s what you want to focus on first. We’ll show you how to do that with our watch list.
Number four is you want to focus on building long-term consistency. Consistency long term just basically, comes down to a math and numbers game of small trades, high-probability and basically, keeping everything targeted towards one probability of profit. Again, we’ll go through this here in detail.
Now, the first thing is obviously, account-size adjustments. Now, we have got a cool, simple guide here on Option Alpha. It’s 100% free. It’s our Account Size and Portfolio Adjustment PDF.
It, runs through this entire process start to finish, but what you want to focus on is that at Option Alpha, we suggest an account size or trade size of 1 to 5% allocation per trade. That means if you get into a new trade in Chipotle, then Chipotle is 1% and then a new trade in Apple, that’s 1%, and then a new trade in Microsoft, that’s 1%.
Whatever percentage you feel comfortable with as long as it’s no more than 5% of your account balance because as soon as you start getting over 5% allocation, the likelihood that you have a run of trades that go against you, because you can't control it, and you don't know when those trades are going to happen.
The likelihood that you have a run of trades that go against you and blow up your account is exponentially higher. That’s why unlike many, many other services out there, we suggest small, small, small portfolio sizes, probably smaller than what some of even the biggest education houses out there say.
Now, this being said, this also means that small can be about your portfolio size. If your portfolio size is in here, then a 1% trade in that portfolio size would be here. Again, as you grow as a trader and as your account balance grows as you start making higher-probability trades, that doesn’t mean that your allocations should stay the same dollar wise.
Your dollar allocation should go up, and you can see as your portfolio grows, your dollar allocation goes up, but it’s the same percentage of your equity that you’re still risking with each trade. That’s the key thing. This is how you’re able to scale and grow.
Now, I can tell you this honestly, and this is after coaching hundreds and hundreds of people. We’ve had a couple of thousand people go through our trading program every single year.
I can tell you right now if you can't trade profitably with a small account, there is no reason on earth which makes me believe that you could replicate that, replicate your trading activities and then magically be successful with a larger account if you can't first trade profitably with a small account.
I’m here to tell you that if you have a small account, it is not something that is going to deter your success. As long as you’re committed to doing this and doing it right, and you have realistic expectations, you can make money with a small account.
Now, are you going to make $10,000 if you have a $5,000 account? Not, you’re not going to make that type of money, but if you consistently stay engaged and make sure that you’re doing the right things, then it will prepare the foundation and the base for you to then start trading more and more money into the future.
Again, if you can't be successful trading a small account, don’t even think that having more money is going to make you a better trader and more successful. You’re not magically going to get smarter overnight because you start with $50,000 versus five.
Now, the one asterisk I did put with this is that we have to make sure that obviously, the trade size that we’re doing is appropriate for our account level.
Sometimes, that does mean that if you’re trading small accounts, like under $5,000, sometimes, it’s going to be hard to find a trade that is 1% of your account balance, which is $50 of risk.
We’ll go over an example here just to show you what we’re trying to accomplish and do. That might help make a little bit more sense with this account-size adjustment thing.
Here’s an example here of just a simple vertical credit spread that we put together a while back on SPY. You can see that the max profit potential here is $29 and the max risk, which is how we base our basically, account size is on this buying-power effect or max risk.
Sometimes, it’s going to be a little bit different because of commissions and margin and things like that. We usually like to focus on buying-power effect. That’s usually a more traditional way to focus on it because that’s what brokers hold in margin for some of these trades.
In this case, if our max buying-power effect or max margin is $73.50 and if I’m trading in an account that only has $5,000, then that $73 is going to be higher than a 1% allocation. If I’m going to target 1%, I may, in that instance, need to allocate a little bit more money, maybe 2% per trade.
It’s obviously, safe to move between one and two or maybe two and three. If you have a really small account, I would highly, highly suggest that you stay away from the 4 and 5% allocation range until you get comfortable with trading and making higher probability trades.
That doesn’t mean that you can't go up there. We have definitely been known to go up there, but I can tell you honestly, where I hang out, 90% of the time is I hang out in the 1 to 2% region because I want to reduce the risk of one single trade going completely against me and blowing up my account, so that’s what we want to do.
Again, that does mean that if you are trading just one vertical spread, again one vertical spread in this example here has $73 of risk. If you’re trading in a larger account and you want to do five of these, so five of these vertical spreads, that would be $365 of risk.
You can do five of these trades as long as your risk for those trades is less than $365. If you are trading in, let’s say, these two accounts, so you have a $20,000 account or a $15,000 account. You can allocate 2 or 3% respectively.
That would still be a decent allocations because your risk on the trade is $365 for that, those five contracts that you’re trading, which is less than your allocation allotment that you have.
You can only allocate $400 per trade or $450. Five contracts would be $365 of risk. That would be an okay trade to make. That would be an appropriate account size trade based on your portfolio and how much you want to allocate.
Again, I highly suggest if you’re starting out, you shy away from doing the 4% and 5% type range allocations. Make sure that you are better off with some of these trades; you understand the concepts, and how things work before you start increasing your position size.
Listen closely on this one, or you will lose money, I guarantee. If one trade is too large for your account, then do not make the freaking trade. I don't know how many people over the course of my career doing this I have told not to do this and inevitably somebody will.
It might be you, or it might be somebody else, but it will always, always, always come back to bite you in the butt because Murphy’s Law always applies here, meaning you start playing outside of the sandbox and something bad is going to happen.
Here I am again telling everyone if you have a trade that is too large for your account, then don’t make the freaking trade. Move on to a different trade. Find a different risk-defined strategy.
Find a different stock, a different ETF or don’t make a trade at all and just wait for a better setup. It is not worth forcing a trade into the market because it could be the trade that blows up your account.
All right, the second thing that we want to talk about with small accounts is focusing on risk-defined strategies versus undefined or naked risk strategies. What this means is that with a small account, you want to be super, super sensitive to, again, controlling risk so that one single trade does not create either a high drawdown or a situation where you have a big margin call or blow up your account.
All of those things that could happen, we want to minimize those with smaller accounts because, with a smaller account, you need to focus first on gaining that consistency and those high-probability trades to generation income. You don't want to be taking on a huge amount of risk.
That’s why position sizing is first important. We want to be making sure that our position sizes are appropriate for our account size, but that also means that we want to focus on risk-defined strategies, so things like iron condors, credit spreads, some calendars, if you want to do some of those, debit spreads, if you want to do debit spreads.
Anything that has defined risk because then you can control your position size as we looked at just a couple seconds ago. If you know it’s got defined risk of $365; then you can control your position size as you get into a new trade.
With these undefined-risk strategies, which are more profitable for larger accounts, they’re not as appropriate for a smaller account because margin can fluctuate. If you don't have enough capital to withstand that margin fluctuation, it can be very harmful to your account.
For that reason, we highly suggest you stray away from the undefined-risk strategies. Now, that doesn’t mean that you can't convert if you are signing up for a Pro or Elite membership to follow our trades.
That doesn’t mean that you can't take a strangle that we do and convert it into an iron condor or take a straddle that we do and convert it into an iron butterfly.
In fact, we all always give guidance for anybody who has got a small account or an IRA account on how you can convert any trade that we do into a risk-defined kind of counterpart or risk-defined brother-sister type trade.
That’s the key here, risk-defined strategies. You stay away from the naked positions because the margin can fluctuate. It can increase dramatically when things go really bad. You just want to be sure that you have enough capital to handle those.
Again, in our opinion, I think that’s accounts over $25,000 can start slowly getting into those types of trades. Under $25,000, you’ve got some different goals you need to hit first.
All right, the third thing that we want to talk about is high-probability, high-IV trades. Now, remember, our edge in options trading is the ability to consistently sell high implied volatility setups that historically are overpriced.
This gives us the widest possible margin for error while still being able to make money. We’ve talked about this numerous times before in the past, but this is the key to everything is able to sell super high implied volatility stocks that have overpriced options, that are far out, that give us a chance of success.
Now, what we’ve done here at Option Alpha is we’ve put together our in-house and built our in-house watch list software that helps hopefully accomplishes this goal for you and makes it incredibly, incredibly easy.
When you head over to the watch list page, you’ll see this. It’ll have live market data if you’ve obviously, purchased access to the watch list. One of the things you can do is just quickly toggle on and off between high implied volatility and not.
Now, you can start to narrow down the focus of everything that you’re trading, and you can look at highest implied volatility stocks only, so anything with an IV rank over 50. You can then sort the list highest to lowest.
You can say, “Okay, look, Nike right now has the highest implied volatility of everything that we have. Now, PBR has the second highest, MON, et cetera, et cetera.”
Now, you can choose to trade these low-hanging fruit strategy or stocks first. It makes the entire scanning process so much easier. Now, within each of the strategies, you can see that if you open up that particular dialogue box for IV rank, it also helps you with showing you what strategies work best.
Of course, we have the small account or IRA account alternative in here as well. You can do a straddle or a strangle here, but an iron butterfly also works really good if you have a small account.
This makes it incredibly, incredibly easy for you to figure out exactly what you want to trade. If you just want to focus on ETFs and not any earnings trades, you can see there’s only right now, two ETFs that have high implied volatility.
Again, you open up that dialogue box. You can see you can do a credit spread, a butterfly, an iron condor, all acceptance types of trades for small trading accounts.
The key here is focused on this low-hanging fruit first. You don't want to focus on stocks that have low implied volatility. You want to focus on just the ones that have high implied volatility. Again, hopefully, that helps to have that watch list available here on Option Alpha.
Now, the last thing that we have to talk about is long-term consistency. You see, people always ask me, “How do I be more consistent with my trading?” It’s real, really simple. It’s just a matter of being persistent and consistent at the same time.
You got to have both of those. You can't be one or the other. Here’s where I want to start. The law of large numbers states that as a sample size grows, i.e. the number of trades, the mean will get closer and closer to the expected value of the whole population.
Now, this is a law in statistics and math. That basically, means that the more times you trade, the closer you’re going to get to the probability that you’re targeting. We’ll talk about this here a little bit more. Let’s use a quick example of a coin toss.
We always use this example in a lot of the coaching and webinars that we do, but it’s so, so critically important. If you start flipping a coin, we know that there’s a 50-50 chance of it being on heads or tails.
If you start flipping that coin the first time and you hit, and you got a heads, then we know the next flip has a 50-50 chance of being heads or tails, but what if you get another tail, or I’m sorry, another head and you get another head and you just keep getting heads, heads, heads, heads, heads?
There has to be a point at which the number of times that you get heads is going to be directly offset by the number of times that you flip tails. If it’s a fair, two-sided coin, eventually, the more times you flip that coin, the closer and closer it’s going to come to the expected result, which is basically, half heads and half tails.
Now, one little case study that we just ran just on a random number generator site here, it basically, had the number of tosses and then the number of heads that we received over time.
This was random, so it wasn’t just linear like, after 100, you get 50 heads. This was basically, a random number generator system. After the first four rolls that we had, we basically, had one trade that was headed.
Now, you could relate this to options trading and say, “If I’m making a trade that has, let’s say, a 70% chance of success, I make four trades that have a 70% chance of success. After four trades, only one of them becomes a winner.”
That’s random, and that could happen. The reality is, is that most of you would say after four trades, “Well, this doesn’t work, Kirk. It doesn’t. The numbers don’t work. I made a 70% chance of success trade, but it didn’t work out.”
It didn’t work out because you just didn’t trade enough. What happens is that after we rolled the dice or, I’m sorry, flipped a coin 100 times, we ended up with 64 winning trades. Now, we’re doing better than the 50% expected for heads.
After we had done 1,000 rolls, we ended up with 582, so again, slightly better than the expected, but then after 10,000 times that we flipped this magical, random coin here, we ended up with 4,989 number of heads, almost exactly 50%.
The reality is, is that the more you trade, the closer and closer and closer you’re going to get to your expected probability, whatever you’re targeting. Now, the way that we always relate this is to think about your trading on a probability scale.
If your target is 70% winners, which by the way, that’s our target here at Option Alpha. That’s where we build most of our trades is to about a 70% winner. We find that that’s the best risk-reward for us historically.
If your trade target is 70% or 80% or whatever the case is, then all of your trades that come down and this is a trade, just one little trade right now, and we’ll just do more trades. All of your trades that fall into this trough here are going to land somewhere around 70.
Now, the more trades that you make, then the higher the probability of all of those trades stacking up and creating a normal distribution around 70. If this is 70 and, let’s say this is 50% of the time you’re winning and this is all the way out here.
Let’s say that this 90% of the time you’re winning trades. Then basically, what’s going to happen is, is that when you start making these trades and I’ll just copy these over here. Your first trade that you might make might be a little, a loser or maybe it was fairly profitable but not as profitable as you thought.
Then your next trade that you make is a little bit better. Now, it’s a big winner. The next two trades that you make after that, those trades are both losers as well. Now, you’ve got a couple of losers after making just four trades.
You start thinking to yourself, man, I’ve got a couple of losers just like that coin toss thing. Where I’ve got a couple of losers, this thing isn't working out. I’m trying to get trades around 70% chance of success here.
Now, you start making, even more, trades, and you can see we’ve got even more trades that are popping up here on the chart. Now, a lot more of your trades are now falling in that 70% win-rate-type target.
Now, as you start increasing the number of trades that you’re making, again, all small trades, you’re going to have the vast majority of them fall into this 70% or so win rate range. Yeah, you’re going to have a couple of trades that are outliers, so one really bad loser, one amazing winner.
That’s going to naturally happen, but again, it’s creating that normal distribution payoff diagram that we’ve all come to expect. That’s been proven time and time again as you increase the number of trades and consistency that you have.
Here’s the deal. You’ll hit what you’re aiming for. It’s just as simple as that. This is why trade size and high probability are so important for smaller accounts. You have to be able to place enough trades so that one, over time, the number of trades will work out in your favor, and they will just like a coin flip.
Number two, more importantly, one individual trade cannot wipe you out. If you have a trade size that is too small and you’re not placing these high-probability trades like we’re showing you how to do on Option Alpha, one trade can wipe you out if you do something really stupid.
We don't want that to happen. We want to mitigate that risk by controlling our trade size, focusing on where our edge is in options trading. If you do that, everything else will take care of itself. Hopefully, you guys enjoyed this video.
If you have any comments or questions, or feedback, please let me know in the comment section right below. If you love this video and you want to share it with other people online, please do so. Help us spread the word here about what we’re trying to do at Option Alpha and until next time, happy trading.