Allocating capital used to be a cumbersome and time-consuming process. Before opening new trades, you had to break out your calculator or spreadsheet to manually calculate risk and position sizing percentages. That's, of course, if you remember to check your position sizing before each new position.
With automated trading, smart traders create highly efficient capital allocation systems that automatically adjust position sizing. Plus, bots don’t make mistakes and never forget this critical step.
In this week's show, we'll spotlight unique and automated ways to allocate capital inside your bot portfolio and discuss what you should consider when building your trading strategy.
We encourage you to think critically and deeply about how you are allocating capital now and how you could improve it moving forward with the help of bots and automations.
What is Capital Allocation?
Capital allocation is how you distribute capital in your portfolio.
With bots, you can earmark different capital allocations to different bots running different strategies.
What is Efficient Capital Allocation?
Efficient capital allocation is the art of distributing capital so that you can get the most out of your portfolio.
The ‘Goldilocks’ approach is that too much is not good, but neither is too little. You don’t want to be 100% invested, but you need to have enough capital working to make it worthwhile.
There is an excellent reason to keep roughly half of your cash idle. Options are already a leveraged trading product. If the invested half of your portfolio blows up, you still have money to keep the business running.
The key is to think about capital allocation holistically. Strategy is just one piece of the puzzle. Allocation is more important for balance and risk management.
Allocating with Bots
Think about your different automated strategies as an “army of bots.” Each bot is a specialized, highly-trained unit that executes a specific mission objective or strategy.
Each bot is allocated a specific amount of capital, so you can easily track and deploy your “troops” efficiently and intelligently.
Old School vs. New School Investing
The old-school investment thought process is to throw your money at something just for the sake of being invested. This is a bad idea.
The new school investment thought process is to think of your portfolio holistically and strategically allocate capital to complementary trading systems.
Bots make it much easier because you don’t have to manually execute different strategies all at once. The bots do it for you.
Examples of Efficient & Inefficient Portfolios
Inefficient Portfolio Allocation
Assume you have a $10k portfolio and one bot running with a $5k allocation. If the bot opens ten new positions and uses $3k of margin to cover those positions, approximately 40% of the bot's allocated capital is still available. Of the full account, you’d still have 70% of your capital unused.
This is inefficient for many different reasons. Let’s also go through an example of efficient allocation to understand them.
Efficient Portfolio Allocation
Again, assume you have a $10k portfolio. You have five bots running with a $2k allocation each. Those five bots open four positions (20 total positions total) and use $6k of margin to cover the positions. This leaves approximately 40% of the bots’ allocated capital available. But, only 40% of your capital is unused of the full account.
Pros of Using the Efficient Model
You can see where different strategies or tickers lead to improved or degraded performance and adjust those individual strategies.
Efficiently distributed bots allow your portfolio to adjust entire trading systems on the fly, whereas you'd have to turn the whole bot on or off with one bot.
You can easily add entire trading systems quickly by cloning bot templates that complement your core strategies.
How to Use Bots to Help Manage Capital Allocation
You can use pre-trade filters to check if there is enough capital to open a new position before sending an order to your broker.
Another recipe can check if the bot’s available capital, net liquidity, maintenance, open P/L, or total P/L is greater or less than some amount. The bot can then make adjustments to position sizing for new positions.
You can also use bot tags. Tags enable you to work through progressive or dynamic allocation adjustments.
For example, suppose the bot’s P/L is below a specified amount. In that case, you could tag the bot as "Lower new capital allocation," which would drop all position allocations from 1% to 0.5% until the bot recovers.
You can adjust position sizing dynamically for better opportunities. If you are trading iron condors and have a decision recipe in your bot that checks if IV rank is above 50, you can tell the bot to allocate 1.5% to new positions. If IV is under 50, you can automatically tell the bot to allocate 1%.
One Framework to Use In Your Account
If you have ten bots, keep 50% of your total capital in cash and allocate 5% of your account to each bot. Risk between .5%-1% per trade. This ensures that half of your portfolio is always safe and the other half is allocated evenly between your ten bots, with each position only risking 1% at most.
- How do you handle excess capital allocated to each bot?
- Do you over-allocate to each bot beyond what is required for full positions?
- Should you consider running each bot near full allocation and leave portfolio cash available but un-allocated to bots?
- Do you rebalance allocation to bots after a string of winners or a series of losers?
The goal of this show is NOT to tell you what to do or how to allocate. It's to encourage you to think critically and deeply about HOW you are allocating capital now and HOW you could improve it moving forward with the help of bots and automations.