The point of the following money management rules is basically to prevent your account from being blown out. Given that even the most wildly successful trading technique will fail some of the time, it is always possible to get long strings of losers. It is important to minimize the odds of losing your whole account due to such random occurrences.
Portfolio Size
For the initial phase of implementing this plan, my trading account will start with $10,000. As I develop the plan and start showing consistent results and improvements in the process, I will reevaluate how much I can comfortably trade with.
Probabilities
Any trading technique will produce a probability distribution of winners and losers, that depends on many factors. Therefore, even the strongest buy signal is certain to fail some percentage of the time. Due to the nature of random events, it is virtually guaranteed that with enough trades, even the best technique will produce long strings of losers.
If a particular trading technique has a 50% success rate, then that means there is a 3.125% chance of getting five losers in a row (0.5 ^ 5) and a 0.098% chance of getting 10 losers in a row (0.5 ^ 10). While 10 losers in a row may not occur frequently, it will happen eventually if you make enough trades. Increasing the success rate of the technique to 60% lowers the probabilities of losers to 1% and 0.01%, respectively, but still means that it is possible to get long strings of losers.
Therefore, it is important to diversify the portfolio across enough trades that such random fluctuations do not threaten to wipe out the whole portfolio.
Maximum Acceptable Loss per Trade
The goal should be to never lose more than 5% of the total portfolio in any one trade. Of course this cannot be guaranteed due to the possibility of a gap down, but with the use of stop losses it is possible to define the maximum loss per trade with a good amount of certainty.
Limiting the maximum loss per trade to 5% of the portfolio means that it would take a string of 20 consecutive losing trades that all lose the maximum amount possible to take the total portfolio down to zero. For the current size of my trading account, this is an acceptable level of risk. As the size of the portfolio increases, this number should be reviewed and revised downward.
In many cases, it is possible to reduce the potential loss for a trade below the maximum defined here. For instance, if a stock has just bounced off of a support level, it could provide an opportunity to buy a call option. Since the trade is entirely based on this bounce, if the stock then turns around and breaks the support, there is no longer any reason to stay in the trade. Therefore, defining an exit point just below the support level may result in an exit from the trade that is much earlier than would be achieved by waiting for the max loss of 5% of the portfolio.
Maximum Trade Size
The portfolio needs to be diversified over a number of trades in order to eliminate the possibility of one or two big losses wiping out the account. If the whole portfolio is invested in a single position, no matter how strong it looks, a gap down in the price of the stock can be devastating.
Ideally, I would like to invest no more than 5% of the portfolio in any one position. This would require 20 simultaneous trades with 100% loss in order to take the account down to 0. However, given the small working capital being used at the moment, this would severely restrict the potential pool of option contracts that can be traded, so the maximum trade size will initially be set at 10%. Again, as the size of the portfolio increases, this number should be reviewed and revised downward.
Given the maximum trade size of 10% and a maximum loss per trade of 5%, if all 10 trades that are in progress simultaneously go down and take the maximum loss, that would cut down the portfolio by 50%. If all 10 trades gap down simultaneously, the whole account could be wiped out. This seems quite risky, and these numbers should be reviewed frequently and monitored very carefully.
A more desirable situation would be one with a larger portfolio size and a smaller maximum trade size and maximum loss. For example, consider a portfolio with $100,000, a maximum trade size of 5%, and a maximum acceptable loss of 1%. In this scenario, it would take 100 consecutive losers at the maximum loss to bring the portfolio down to 0. It would also take 20 simultaneous trades with 100% loss to bring the portfolio down to 0. If all 20 trades take the maximum acceptable loss of 1%, then it would only cut the portfolio by 20%. This means that there is a lot more room to make lots of trades and allow the law of probabilities to work in my favor.
Position Sizing
Given the initial portfolio size and the maximum trade size, most trades will initially involve just one contract. However, as the size of the portfolio increases and it becomes possible to trade multiple contracts per trade, the maximum loss per trade should be used as another limit on the number of contracts.
For example, if the stop loss on a trade is set such that each contract can lose 2.5% of the portfolio, then the trade should include at most 2 contracts, even if that is less than 10% of the portfolio because that puts the maximum possible loss at 5%. In general, the maximum loss per trade divided by the loss per contract gives another upper bound on the size of the position.
