January 5, 2007, Newsletter Issue #48: Allocation is critical

Tip of the Week

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.

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