While each trader has his/her own unique approach in the market, it stands to reason that most of us are looking to deploy a high-probability strategy that produces consistent positive returns.
If that is the case, then it's critical to be consistent in terms of position size when adding new exposures to your portfolio. A lack of discipline in this area can lead to outsize losses, which can derail confidence and put a big dent in available capital.
For these reasons, the degree of "confidence" we have in any particular trade idea shouldn't necessarily dictate position size. Instead, the risk should be spread equitably across the portfolio and match the profile and investment goals of the trader.
To help reinforce these guidelines, a recent episode of Tasty Bites examined trade sizing in greater depth. We think the topics covered on this show provide valuable perspective and merit a few moments of your time.
Per the episode, consider the graphic below, which illustrates how an outsize position can lead to sub-optimal results:
Notice how the five trades in the sample portfolio above produced a success rate of 80% (4 out of 5 winning trades), but net lost money. This is a perfect example of how "going big" can backfire.
As shown in another slide on Tasty Bites, had the trader simply gone with the same position size as the other four trades, he/she would have produced a positive net return of $200, as opposed to the overall loss recorded with the outsize trade in the portfolio.
In order to avoid an inconsistent application of your strategy, the hosts of Tasty Bites outline a "2x credit loss" guideline for sizing trades. This approach helps account for differences in implied volatility and other factors across positions.
As you can see in the sample portfolio below, incorporating the "2x credit loss" guideline means that the total number of contracts deployed is adjusted to achieve consistent sizing:
Notice how an increase in option premium necessitates a corresponding reduction in the absolute number of contracts traded, and ensures that outsize risk is avoided. Ultimately, this mindset gives us the best possible chance of reaping the rewards of a high-probability approach.
We hope you'll take the time to review the full episode of Tasty Bites focusing on trade sizing when your schedule allows.
If you have any questions related to sizing trades appropriately, we hope you’ll leave a message in the space below or reach out directly at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.