OAP 047: Options Trading Risk Management & The Indisputable Math Behind Optimal Position Sizing

Options Trading
Download The "Ultimate" Options Strategy Guide

One of the key elements of becoming a more successful trader is the ability to absolutely master options trading risk management. And, contrary to what you might assume, it comes down to a couple simple things. Namely, determining and sticking to an optimal position sizing range for each trade and never allocating the full value of your account at one time.

In simple terms; don’t invest too much money in each trade and always have money left over to keep the lights on.

My goal today is simply to help you trade with more confidence. The type of unwavering confidence to go out and start placing trades without the fear of losing or the fear of blowing up your account. For me, confidence comes from understanding the underlying math and reasoning behind optimal position sizes. Too often you’ll hear or see other traders spout off allocation ranges without any clear direction on WHY they chose that range.

If someone told me that I should allocate just 10% of my account towards each trade I’d ask them why? Why this range and not something higher or lower? What’s the reasoning behind 10%? Rarely will you get a straight answer.

The reality is that if you consistently enter high probability trades and stick to the optimal position sizing range we reveal, the odds of completely blowing up your account at any point is 1 in 28 trillion.

In today’s show, I'll walk you through the math behind why I’ve said, for 8 years now, that you should never allocate more than 1-5% of risk per trade. It’s not just some cool numbers I pulled out of thin air. There’s a mathematical and logical approach and I’ll break it all down in today’s latest show.

Key Points from Today's Show:

  • The only thing you can really control is the underlying that you trade, which strategy you choose, and how big your position size is — position sizing is the number one key for success.
  • Always allocate each position or trade on a sliding scale between 1-5% of your account or equity size — based on cash or equity, not what you can borrow in margin.

Max Allocation Per Trade

  • Risk is defined as your maximum loss potential on a credit spread, iron condor, or risk defined trade. When trading undefined risk trades or naked positions, the key is to allocate at least up to the initial margin requirement.
  • When trading in a low volatility environment, allocate towards the bottom end of the 1-5% range, and allocate more towards the higher probability setups.
  • When trading high probability positions, your risk of blowing up your account is infinitely small if you stay under the 5% threshold per trade, and you trade with a high probability of success.
  • Risk management principle: Keep 20-40% of your account in cash, or dry powder, because you do not know for certain what will happen in the market.
  • If you're placing high probability trades and keeping your positions diversified, the odds of seeing consecutive losses on the extreme end of the spectrum is incredibly small.

Odds of Consecutive Losses

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy ?

Free Options Trading Courses:

  • Options Basics [20 Videos]Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to properly scan for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]Honestly, this module isn't just for professional traders; it's for anyone who wants to eventually have options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [40 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type in order to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our call short strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to quickly filter and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.