The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
When it comes to probabilities, we have to understand that there are winners and losers. Even if we have a 99% probability of success on a trade, one percent of those trades will still be losers over a very large pool of occurrences. Let’s say that we reach our true probability over 1000 occurrences. We could expect to see 990 winners and 10 losers. The question is - where will those 10 losers occur? Nobody knows, and that’s the importance of trading small.
Trading small and gathering a large number of occurrences play hand in hand. To put it simply, if we trade small relative to our portfolio size (<5%), we allow ourselves to obtain a larger number of occurrences and lower our portfolio risk per trade. If we have $100,000 and we trade very small and only deploy trades that are 1% of my portfolio, we are looking at a buying power reduction of $1000. This is very small, and puts us in a good position to thrive in the long run. Positions that go against us will not destroy our portfolio when trading this small. On the other hand, if we only have $10,000 and make trades with a buying power reduction of $1000, we’re using 10% of the portfolio per trade, which becomes problematic when we incur losses. Trading small allows us to stay alive when probabilities go against us. Over time, if we trade small we allow ourselves to reach our true probabilities of the trades we route.
Reaching True Probability
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