Investing and Money Management Tips

What is convexity?

One of the benefits of buying options is convexity. When a stock drops one point, a call option with an initial delta of 50 percent will lose a half-point. But the option will now have a lower delta, such that the next point drop in the stock will result in a smaller loss for the option. This "positive curvature" helps reduce an option's price risk on each successive decline in the underlying shares, while the stockholder continues to lose the same one point on each successive drop in the stock. This positive curvature also works in the same manner as the stock moves up. A call option's delta will increase on each successive gain in the stock, allowing the call holder greater upside participation with each successive gain in the underlying share price. Convexity also refers to playing more dollars on successive trades during a winning streak and fewer dollars on successive trades in a losing streak. This preserves capital during a string a losses and provides greater participation during a hot streak.

Allocation is critical

In the same spirit of "staying in the game," we now turn our attention to allocations per trade. We will not attempt to tell you a minimum dollar amount to trade. This is a decision best left to each individual investor that takes into account their overall profit goals and costs of trading (e.g., commissions). Rather, our goal in this report is to discuss the percentage allocation to each trade. In an excellent chapter on money management in New Thinking in Technical Analysis: Trading Models from the Masters (Bloomberg Press), Courtney Smith discusses how to "play the game long enough to master the skills and information needed to become a profitable trader" using a system he calls the fixed fractional bet. Simply stated, every trade should represent a set percentage of your total account. For example, let's say you have $25,000 available for options trading and you wish to allocate 10 percent of your total account to each trade. You would therefore trade $2,500 for your first trade. Assume the trade gains 80 percent, or a $2,000 profit. Because your account size is now $27,000, your next trade would be for $2,700 (0.1*27,000). Now let's say your first trade lost 40 percent (remember you need to let your winners run and cut your more numerous losses short), or $1,000. Your account would now stand at $24,000, meaning that you would allocate only $2,400 to your next trade. Notice how this differs from a fixed-dollar strategy in which you would invest $2,500 in each trade. We should note that with options trading, it is difficult, if not impossible to trade exactly 10 percent (or whatever percentage you choose) on each trade. It is rarely the case that an option's premium will divide evenly into your dollar allocation for any trade (e.g., five $5 contracts, or $2,500). The best solution is to trade as close to your allocated percentage without going over. That is, if your allocated amount for a particular trade is $2,500 and you're interested in a $7 option ($700 per contract), you should trade only three contracts ($2,100). Also, do not let your allocation dictate what option you will play. For example, say you have $2,500 for a trade and your trading system calls for higher-premium in-the-money options. If you have your eye on one priced at 7 (three contracts, or $2,100), don't opt for a cheaper out-of-the-money option priced at 3 (eight contracts, or $2400) just so the total trade is closer to your allocated amount. In other words, don't compromise your trading system for the sake of getting nearer to your allocation.

Consistency is the key

One other thing we should mention. Don't vary the percentage you allocate trade by trade. Don't double up on a trade after a loss hoping to win your money back right away. There's a technique some blackjack players use in which they double their bet after each loss, the idea being that eventually the cards will turn in their favor and they will be ahead. That's fine (we suppose) if you're betting $10 chips since you likely will have a sufficient bankroll to stay in the game long enough for that to happen. But options trading is not so forgiving. The wins are not as frequent, the market may be turbulent and volatile, your system may be flawed, and you might run into a series of trades that will wipe you out. Sure, you may get out of the hole with that one winner, but what if it doesn't come in time? If you're sitting on the sidelines with no cash, there's positively no way to benefit from those big winning options trades. And as the saying goes, you miss 100 percent of the shots you never take. One reason we focus on consistency is that options buying by and large involves more losing than wining trades. In exchange for having more losers than winners, you will also achieve bigger average profits on your winners than on your losers. Success is dictated by using proper money management to stay in the game long enough to reap the rewards of the bigger, though less frequent, winning trades. This brings up an issue that we have not addressed - increasing one's allocation after a series of winners. This is just as dangerous as increasing the percentage after a losing trade. Why is this so? Remember that there will always be losing trades. Guessing which trade will be profitable and which won't will have dire consequences if you guess incorrectly. Putting a higher percentage in a loser and less on a winner will ultimately lead to decreased profits. Of course, allocating more to the winners and less to the losers would result in huge profits. But given that you will likely encounter more losing than winning trades, the odds of picking correctly are stacked against you.

Review your portfolio regularly

We also realize that you may not have the time to evaluate your portfolio on a day-by-day or trade-by-trade basis. However, we still highly recommend that you look at your portfolio situation on a regular basis (monthly or quarterly) to assess how your money management approach is working. You may find that your portfolio has increased in size and in order to maintain the same percentage allocation to each trade, you must up your dollar commitment for the time being. Or, you may find that it is necessary to scale back on your dollar commitment if the portfolio has experienced a setback, so that you are able to stay in the game and participate in the next big winner or winning streak. Furthermore, after a series of evaluations, you may decide that the current allocation (say 15 percent) to each trade is too aggressive. You might then need to back it down because the portfolio fluctuation (volatility) is too much for you to stomach.

You can be successful with a winning percentage of under 50 percent

Renowned investing and trading coach Dr. Van K. Tharp addressed the issue of winning percentages in the November 1997 issue of Technically Speaking, the newsletter of the Market Technicians Association. In his article, "Why It's So Difficult for Most People to Make Money in the Market," Dr. Tharp states, "Most of us grew up exposed to an educational system that brainwashes us with the idea that you have to get 94-95% correct to be excellent. And if you can't get at least 70% correct you're a failure. Mistakes are severely punished in the school system by ridicule and poor grades, yet it is only through mistakes that human beings learn. Contrast that with the real world in which a .300 hitter in baseball gets paid millions. In fact, in the everyday world few people are close to perfect and most of us who do well are probably right less than half the time. Indeed, people have made millions on trading systems with reliabilities around 40%."

It should be noted that Dr. Tharp is not specifically referring to options trading in his discussion of winning percentages. In fact, you should expect winning percentages for option premium buying to be lower than that for trading stocks or futures. Our research shows that successful short-term options traders are correct on roughly 35 to 40 percent of their trades. Although this win rate may seem rather low, there are factors such as fighting time decay and preserving capital by shutting down losing trades beyond a certain point (some of which may ultimately have been winners) that are particularly relevant to options trading. The important point is that positive overall returns over the longer haul result from allowing your profitable trades to run and cutting your losses in other trades relatively quickly.

The concept of limiting losses and letting the winners run cannot be overstated. In his classic work, The Battle for Investment Survival, Gerald Loeb states, "Accepting losses is the most important single investment device to insure safety of capital. It is also the action that most people know the least about and that they are least liable to execute ... The most important single thing I learned is that accepting losses promptly is the first key to success." In addition, Loeb says, "The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures."

Our trading goals follow these principles in that we strive to maintain a winning percentage of between 30 and 40 percent. At the same time, we manage our recommendations such that our winning trades gain far more than our non-winning trades lose.