Lesson Overview

Trade Size & Capital Reserves

We're big believers at Option Alpha in controlling our trade size and capital allocation. We know that options trading is just a game of numbers and probabilities and, therefore, the only way we lose long-term is if we deliberately put ourselves in a position to lose a lot of money quickly by trading individual positions that are too big.

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In this video, we're gonna talk about trade size and capital reserves. It's probably one of the most important topics that we can discuss as we get further into Track 2 here, and this is especially important for those of you who are new to options trading, but maybe even more so for anybody out there that has been an options trader before and hasn't found success.

I can probably assume that trade size and allocation is probably one of the biggest questions people have when it comes to options trading.

So, at Option Alpha we're big believers in the probabilities behind options trading, and therefore the requirement that individual trades must be kept small, and overall capital allocation must be limited.

Now, options trading obviously is profitable because we use leverage to generate higher than average returns on a small portion of our account. That's the whole goal here. But let's not be stupid in assuming that we could make even more money if we allocated more to each trade, or overall.

Because then we put ourselves in a position that we blow up our accounts, and this is what most people fail to do when they start trading options.

So, here's what we say about maximum risk per trade or allocation for each trade, and again, you can download this PDF right inside of our guides and checklists page, but again, we'll go over it here.

And I'll do a bunch of examples because I want to make sure you guys understand this, especially the difference between doing a margin account and doing an IRA or a small trading account. I think it's real, really important.

The first thing you have to understand is down the left-hand side here; these are different account balances. And again, this is based on your total equity or cash.

This is not assuming that if you put $10,000 in and then the broker allows you to borrow $10,000 on margin, that you've got $20,000 available trading funds. No, we're talking about the cash or equity value of your account.

Now, up on the top, we always suggest, and this is something we've done for years and years, we always suggest an allocation of one to five percent per trade, and there's a reason why we have that allocation suggestion.

One, it's low. Two, because as you'll see later on in this video: the numbers don't lie, it's virtually impossible to blow up your account with allocations this low, and that's why we do it.

So, if you are, for example, in an account that has $10,000 of starting capital, that means that you would want to maximum-price your risk, or determine the maximum risk per trade that you can do, of 1% or $100, 2% or $200, 3% or $300, etc.

Now again, what this is telling you is, this is telling you how much risk you can take per individual trade that you do. For me, I think about it as per position that I'm in. So if I'm in a position in SPY, or APPL, or CMG, which is Chipotle, those are all individual positions that I might be in.

I might have multiple contracts in each position, but the maximum risk is never gonna go above, for all of those contracts in that position, never gonna go above my threshold here for allocation.

So again, whatever your threshold is, wherever your account is, you can then determine your allocation. We always also suggest that you focus most of your energy on the 1-3% zone. I think that's a comfortable range to start with, especially if you're a new trader.

If you're an experienced trader, if you can't make money allocating 1 or 2 or 3% of your account balance, you're never gonna make money allocating even more, right? That's just never gonna happen. We fall in this range.

A lot of my trades, and for those you who sign up for a pro or an elite membership you'll see when we send out our trading alerts if the allocation is small, medium, or large. And what we're saying is where do we fall in this spectrum?

Are we towards the 1% kinda medium-sized trade, 3%, or large being a 5%. I typically reserve the 4% and 5%-type allocation trades to super-high implied-volatility trades, where the odds of success are really in our favor, the edge is in our favor with implied volatility, and options pricing is really good.

That's when we'll scale up our position size, but otherwise, I want to stay in this 1-3% zone because I don't need to allocate a lot of money per trade to make a decent return at the end of the year.

So, let's go through an example here, or a couple of examples of how we could allocate some money out. And I'll just pick randomly on this chart here. Let's assume that we have a $20,000 account, and we'll just use some different account values and do a bunch of different examples here.

But let's assume that we have a $20,000 account, and we want to allocate $400 or 2% of our account, per trade. So $400 of risk per trade. So if we go to our charts here, and I just brought up a chart at the time, I'm doing this video of the queues, which is the NASDAQ ETF.

And let's just say that we want to sell a credit spread above the market. So we sell a call spread above the market, and in this case, that call spread is giving us a credit of about $25. So if I hit conform and send, you can see that my max risk on this trade, or the buying power effect that's taken out of the account ...

Max loss is right here, but then when you look at the credits and commissions and stuff like that, you can see the buying power effect is $77.50.

Now if I remembered back to our chart here, we can go up to a maximum risk per trade of $400. So in this case what we could do, because we have a $20,000 account, we could scale this position up to four contracts.

So this is where I talk about either scaling up or scaling down. In this case, if we scaled this thing up to four contracts, that would at least get us to a risk of $310, still under our target, okay? So you could do that, and that would be under 2%. If you want to be right at the 2%, you could scale up to 5.

We hit confirm and send, and you can see we're just now under that 2% threshold of $387 for the entire trade that we're doing. So again, the position or the trade that we're doing, it is five contracts, but the risk in this trade is $387. That would be an appropriate risk size for this particular account.

Now let's assume, for example, that you have a $5,000 account, and you're looking at the same trade, or maybe this is a trade that we did on our pro or elite membership, and you're following that trade.

Well, if we did five contracts or more contracts, and you look at that trade, and you look at your account. And you see that your $5,000 account, to allocate 2% of your account balance for each trade, that $100 of max risk per trade.

Now it might be easy for you just to assume, "Hey, look. Kirk's doing it at this higher level, he must believe in it somehow," or whatever the case is, and that's not the reality. The reality is I'm just playing a numbers game, and you should be playing a numbers game too.

So if you can only allocate $100 of risk per trade, and if we are doing a trade where we're selling five contracts that have $387 of risk, then you need to scale down this trade, to something that's more appropriate for you.

You might have to scale this down from five to one contract. So now you can see when I open this dialog box up, that this one contract has $77 of risk. That is below your $100 threshold for your account, okay?

So this is how you figure out exactly how you can, again, manage your risk, get into the appropriate position size. And it's all based on this buying power effect that you have or a maximum amount of risk. Okay?

Now let's take a different example, and let's go back to our risk chart here. Let's say that we have a $50,000 account, so we've got a slightly larger account. And let's say that we want to allocate 4% of our money to each trade or each position that we're doing.

Again, we can do multiple contracts you need to position, but we just want to allocate 4% of our account to any given position. So that's $2,000 of maximum risk. Well now that we're in a $50,000 account, we do have the ability to possibly trade some naked or undefined-risk positions.

So let's say that we want to sell the 113 calls, and go down below the market and sell the 97 puts, creating a strangle in the queues.

Now you can see that we've taken a little bit more money here because we're doing this undefined trade risk, and we do in fact take in a maximum potential profit of $117, which is exactly what the credit is that we used for selling that strangles.

And now we also see that the broker is keeping in the margin to hold this position open, this buying power effect or this margin amount of $1,573. Now, this is right below our threshold of $2,000, so it is an appropriate position size if we want to allocate 4% to this trade.

Maybe this a high probability trade, great implied volatility, it's got great liquidity. I could see why you could if you wanted to, scale up a little bit to the 4% level.

But if you wanted to do more than one contract, so let's say you wanted to do two, and you were just not really paying attention and looking at your risk, you could see, hopefully, that your risk now in this trade, or the margin that's being held in this position, is now $4,147.

That's over your 2% threshold that you said you would stick to, and in fact, it's over the 5% maximum threshold for any one trade. What this does, is this opens you up to a lot of different risks that you should not be taking on, as an options trader.

This is one of the ways that you can control and manage your risk, and prevent a lot bad things from happening, is by managing this aspect of the trade, not trading more than 5% risk per trade.

This trade had $3,000-plus of risk because you assume that it was necessarily going to be a good trade, or you liked the trade or many different multitudes of reasons why you could have scaled up into this position, but that's not what you want to do in this case.

You don't want to do that because you're gonna be going over that 5% allocation. You want to scale down, or do something a little bit different, okay?

Let's again take another, different approach to this. So let's keep the same approach, saying that we want to get into this position.

For some reason you want to do these two contracts, these strangle contracts, or maybe we did two strangle contracts in our pro and elite membership level, and it's probably too big of a trade size for your account.

So, what you can do is you can convert this trade into a risk-defined counterpart. Just like we always suggest in our trading alerts when we send them out, if we do a strangle or a straddle, we'll always suggest which options you can buy to convert this into a risk-defined counterpart.

And that's gonna reduce the risk in the trade. So in this case, we sold the 97 puts below the market. We could also go in here and buy the 95 puts, and that'll create some defined risk on the downside.

Above the market we sold the 113 calls, we can go up and buy the 115 calls, basically giving us a nice iron condor with about a $2 difference in pricing or a $2 difference in the strike prices that we sold.

So you can see here, this is our nice new iron condor, we've got the same number of contracts across the board, and a $2 difference in the strike prices both on the call and the puts side.

Now our credit's been obviously reduced dramatically to $48. But now when I hit confirm and send, you can see now that the risk in this trade was also dramatically reduced to $314, okay?

So if you have a $50,000 account, that still might be a small position for you. You could probably go a little bigger in position size. So what you could do is you could widen out your strike prices.

Let's say we, instead of doing the 113/115 we do the 113/117, and the 97 put, and the 93 put. Okay, so now we take in a little bit more premium, and we start scaling up our risk, okay?

So the same iron condors that we can get in, now we've widened out the spreads on either side, we can start playing around here a little bit with the risks. So a little bit bigger position size, little bit more risk.

You don't have to sell as many contracts. You're still selling the same number of contracts, but now you can, again, appropriately control some of your risks, okay?

So hopefully that makes sense of what we were talking about, about just making sure that the risk in the trade that you're taking on, not the contracts but the risk in the trade, is within these targets. Okay?

It's insanely important that we go through this, so listen closely, or you will lose money: if one trade is too large for your account, then, well, let's see ... Don't make the freaking trade! I don't know how many times I've probably had to tell people this, and maybe I'm the first person to tell you this.

If I am, that's a shame, and it's really bad for this industry, but the reality is that if a trade is too large for you and you can't scale down ... which you should be able to scale down almost every trade that we possibly can send out and suggest, or any trade out there can be done on a very small scale.

If you still can't scale down so that your risk size is 1-5%, then you don't need to be making the trade. You can find other trades. There are tons of trades that have very small risk sizes per trade, okay? So that's real, really important.

Let's talk about overall allocation. Here at Option Alpha, and again this is different than other people out there, we never suggest that you allocate more than 50-60% of your equity or cash to your positions. This means that if you have $100,000 in an account, at least $40,000 of that is in cash at all times.

That might sound a little weird to some of you, initially, but again remember: our goal is to make a larger return, an oversized or greater return on that 50-60% of our equity that's invested in options, but still have some cash in the bank to help buffer some of our positions. And we'll go through why we do that.

If you remember back to the expected portfolio video, remember that we said even if we had invested just 25% of our account, and we were generating, let's say, a quarter of a percent per day in return on capital, which we went through all those calculations on how you can figure that out, then we'd still be generating an overall return, not just on the 25% that we have invested but on the entire account balance, of 22.8% for the year, okay?

So it is not out of the realm of possibility, because we showed you how to do it in those calculations, it's not out of the realm of possibility to generate a very decent return on a small amount of your money invested, and still have a great overall return, even keeping a ton of money in cash, okay?

And that's a key point. So we don't have to invest all of our money. Now, why do I say keep this 40%, 50% of our money in cash at all times? Well, number one is margin expansion. If you are starting to trade on margin, meaning naked or undefined-risk trades, which you really shouldn't be doing unless you've got a $25,000 account or more.

Then what you'll end up seeing if you trade long enough is that margin can expand. Meaning that if I went back and I sold these options like I did before, in the queues, if the initial margin on the trade is $1,600, but then the next day the market is crazy, volatility jumps, all these things happen, that margin can start to expand.

Meaning the brokers can start to arbitrarily collect more money to cover a bigger potential loss because volatility in the market has increased. The position may not have moved. The queues may have stayed the same.

But margin in the market or volatility in the market could have expanded, and that created the broker to hold more of your potential cash in-margin to cover the position. That margin expansion can be up to 150%, that's why we have to keep that initial position size really small.

Number two is, we have to keep dry powder for new trades. One of the biggest opportunities for us as traders is when implied volatility is insanely high. If you think about it, most of the time when implied volatility is high is when the markets are falling, and falling very fast.

And most traders don't have enough money to get into new positions during those time periods when our edge has been maximized and is at its greatest point.

So, I think you should always have some money available, for either new trades or new adjusting trades if you have to cover and protect some trades. You can't do that without first having some cash leftover.

Number three, probably one of the most important things, is you've gotta have money left over to keep the lights on. The concept of keeping the lights on, for me, means that if the world were to implode tomorrow, and everything went to zero for some reason.

Which, I don't think that would happen, but if it did, if you're the person that thinks doomsday, doomsday, doomsday, if the world were to implode and all markets went to zero, you gotta have money leftover to keep the lights on.

And more so, because we know that the probabilities are gonna work themselves out over time, we also know that it's possible a black swan event could come and hit us tomorrow.

And if we lost 50% of our account balance tomorrow because of a black swan event, that would suck, but we'd still have money leftover to keep trading and to go forward.

If you have all of your money invested, and a black swan event or even something close to a black swan event comes and knocks out 50%, 60%, 80% of your account balance, then you're put in real hard place to keep the lights on and keep making money and get back on the wheel and start working. Okay?

And number four is, you'll never be forced into a situation that you can't handle, i.e., a margin call. You know it's funny because a lot of the coaching students that I have, before they get started with us, and they have too much money allocated, one of the major concerns that they have is a margin call.

And I can tell you right now; a margin call only happens when you don't have enough money in your account to handle the positions that you have. Margin calls are bad because they force you into making decisions that you don't necessarily want to make at the time.

So, brokers might force you to close a trade, or to exit a position, or to add stock or remove stock. They force you to do things that you might not necessarily want to do, and the only way to avoid that is to have enough capital available so that you're never in a situation where you need to be margin called or be forced by a broker to do anything.

Again, you don't even need to invest all of your money anyway, so this is a moot point. Because again, with expected portfolio returns you could have 25% of your portfolio working hard for you, the other 75% sitting in cash, and still generate 15-20% a year, okay? Not out of the realm of possibility.

All right. This is another thing I want to go over. This is something that we calculated out, and I think is insanely helpful. And I want you to spend some time on this chart, even print it out and put it on your computer if you need to.

This is the probability of seeing, or probability or odds. However, you want to think about it, the odds of seeing consecutive losers based on different probability levels.

So if, for example, you're trading at the 50% probability of success level, which is basically where stock traders trade, by the way. So if you're day trading and you're a stock trader.

This is basically where you hang out, a 50% chance you make money or not. Then, the odds or probability of seeing one consecutive loss in a row is 1 in 2. Makes sense, right? So one trade you're gonna win, one trade you're not. The odds of seeing two consecutive losses in a row is 1 in 4.

The odds of seeing five is 1 in 32. The odds of seeing ten consecutive losses, as a day trader, not to say that you're gonna make money trading, but that you gonna see consecutive losers one after another, is 1 in 1024. Okay? So, low odds.

But now you can start to see that as you increase the probability of success that you start trading at, so as you start moving away from stock trading towards options trading.

And you start trading at either the 60%, or the 70% chance-of-success level, or the 80% or the 90%, now the odds of seeing two or five or ten consecutive losses in a row is insanely small. Okay?

Where we hang out in most of our trading is at the 70% chance-of-success level. So for us, people always ask, "Well how many consecutive losers do you have in a row?" We could have one or two, but the odds of actually having ten consecutive losing trades in a row, that we put out, is 1 in 169,350.

So, insanely low odds that we're gonna have ten consecutive losers, based on the math and the probabilities. So what's important to understand here is that, if you are trading at a 5% allocation level, okay?

5% of your account allocated. You could basically at any one point have 20 positions on. And this is the key point here that I want to make about consecutive losers. Nobody talks about this in this industry; it drives me crazy.

If you are trading at the 5% allocation per trade level, which is our maximum suggested allocation, okay? And there's a reason why, and this is it. If you're trading at our maximum suggested allocation, at any one point you could have 20 positions open.

That's if you're investing 100% of your account, right? So 100% of your account, 20 positions made up of 5% each. That means the odds that you lose, as long as you trade high-probability, are like 1 in 90 million or better. Okay?

Think about that. The odds that you lose, taking maximum risk of 5% per trade, even if you invested all of your accounts, which we never suggest you do, 100% of your equity into these 20 trades, the odds that actually lose on that portfolio is 1 in 90.9 million, if you're trading at the 60% probability-of-success level.

If you trade where we trade at the 70% level, it's 1 in 28 trillion. Okay? So I'm here to tell you that you have a very, very low likelihood of blowing up your account and losing money if you understand the math behind the probabilities and the odds and position sizing.

This is why we go over this so early in Track number two here because it's so critically important. If you blow up your account, I guarantee you did one of these things wrong.

And it wasn't necessarily that you picked a bad stock or bad trade or whatever, it's that you either allocated too much, you had too big of a position size, or you didn't make enough trades.

And that's it. I can guarantee that all bad accounts, bad trades, blown up trades, blown up accounts, basically come back down to these numbers. Okay?

So, hopefully that actually gives you a little bit of confidence as you move forward, understanding that, hey look, this stuff could work out, because even if I get hit really, really bad, even if a black swan event happens, I'm still gonna be in a good position to make some money in this business long-term, if I keep my eye on the ball.

The question becomes, "How many trades should I place?" This is a big one, and this is one that I wanted to cover here because it talks a little bit more about consistency. We always say you wanna place as many trades as possible.

You don't wanna force trades. So there's no point in forcing trades into the market just for the sake of making trades, but if the market setup is good and the pricing is fair, make the trade.

Again, your goal over the course of your career should be to place thousands upon thousands of high-probability trades.

Because remember what we talked about before with consistency is that the longer you trade and the more trades you make, the closer that you're gonna get to your expected outcome or your expected probability that you're targeting.

So if you're targeting the 70% chance-of-success level, you may not make 70% winners, or you may not have 70% winners on the first roll, or the second roll, or the second trade.

But if you make 10,000 trades over the course of your career, it doesn't have to be the first month or first year, but it may be over the course of your career, you will hit almost exactly 70% winners vs. 30% losers. It's just how the math works out.

Same thing with this coin toss theory that we've talked about before: the more you flip the coin, heads and tails, the closer and closer you're gonna get to the expected probability and outcome, which is half heads, half tails. It may not happen the first time, may not happen the first ten times or hundred times, but it's going to work its way closer and closer and closer to that.

And so again, as long as you keep your position size small, you have the opportunity to withstand and hold and work through a couple of strings of losing trades, and not blow up your account as you get your trade size up and your number of occurrences up.

Okay? Insanely, insanely important. I hope you enjoyed this video talking about trade size, allocation, capital reserve.

Hopefully it enlightened you a little bit to what the numbers are, about how often you could lose or would lose or blow up your account, and starts to bring together all the pieces that we've been talking about in Track 1 and Track 2 here on Option Alpha about how you can make smarter, more profitable trades.

As always, if you have any questions or comments, please add them in the comments section below. If you love this video, please let us know, share it online, help spread the word about what we're trying to do here at Option Alpha.

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