New Option TraderLearning how to be a successful option trader and blogging about it

Anyone who trades actively had to learn at some point that losing is just part of the game.  It doesn’t mean you’re a bad trader, it’s just the way probability works.  You can’t control the market but you can control how much you lose on any single trade.  There’s absolutely no reason anyone should ever lose their entire account just because of a “bad month” if they’re sticking to their money management rules.

Now, as we get more experienced we’re able to spot the higher probability trades and (ideally) go with those.  But, there is no sure thing in trading and a bad week or two that comes out of nowhere will turn any trade no matter how good the setup into a losing trade.   That’s why money management is so important  — it stops losing trades from going too far in the losing direction and lets the good trades run.  You really only need to be right about 35% of the time to be a successful option trader with sound money management rules in place.  That may not sound like a lot but remember — options are leveraged instruments.  A little goes a long way…

Think about money management as risk management because that’s what that it really is — managing your risk with every trade by limiting how much you put into each trade. Most people dive right into learning option strategies right away and only come back to money management after a few bad trades This really should be the other way around.  Good money management habits should be at the beginning of the learning process and every single trade so you don’t get wiped out with one bad trade which can happen no matter how good you think it will be — otherwise you’re just gambling.  Smart traders trade with a plan and that plan includes rules about money management.

So, what are some good money management rules?

1. Don’t lose more than 2% of your total account capital on any single trade.  2% is the generally recommended percentage. Think about it.  If you never lose more that 2% on a trade, that’s pretty safe, right?  Let’s put this into perspective.  Say, you have $25,000 in a trading account.  This means you will not lose more than $500 on any single trade.
2. Now that you know the most you want to lose on this trade, figure out where to put your stop loss so that you’re out the minute you’re at a $500 loss.  There are various formulas for figuring this out.  Below are two other sites that do a spectacular job of describe positioning sizing formulas, so I won’t go repeat them here.

Money Management and Position Sizing

• Position Size
• Money Management 101

Money Management Key Points

• Comes down to planning your trade and having the discipline to follow that plan
• Determine amount you are prepared to lose before placing the trade — that is the amount you will risk
• Figure out your position size based on the amount you’re prepared to risk
• Stick to the plan no matter what

It can be tempting in a bull market to let it all ride on a single trade.  This may work out once of twice but eventually you will end up giving it all back.  Especially with the volatility swings we’ve been seeing lately, what looks like a no-brainer high probability trade can very easily turn against you in the last two weeks before expiration leaving few options but to take a loss.

More than anything else smart money management is what determines trading success.  Remember, it’s not about making the big wins on every single trade but minimizing the losses and living to trade another day.  Look at it this way, if you have a spectacular month and make 300% on every trade — and each time you’re putting 80% or more into each trade — all it takes is one bad trade to take away all your gains and maybe even your whole account!

The goal here is not only to preserve what you have but grow that capital at a steady pace.  There will be losses along the way.  But, if you’re only risking a small percentage of your account then that’s the most you can lose on any one trade.

I was going to post money management rules in this post but then realized this is actually a bigger topic that deserves more than, “dont’ risk more than 2% on any trade..”

So, consider this an introduction to money management and stay tuned.  I’ll be back in the next post with a more information on what money management rules to consider when placing a single trade and for your overall trading strategy — yes, it is that deep.