Money management is the term used to define different allocations in your trading plan. These include:
- Total dollars set aside for longer-term investing and shorter-term trading,
- Maximum dollars allocated for specific markets, systems and/or strategies,
- Maximum dollars identified on a per trade basis and
- Maximum dollars at risk.
These components are part of a complete trading plan—and absolute necessity in these volatile markets. If you’re trading without a plan and don’t know where to begin, the Optionetics Home Study Course is strongly recommended (go to www.optionetics.com/tools/homestudy/cs/ for more information). It may not be the most exciting topic in the world of trading, but excitement shouldn’t necessarily be a goal for those seeking longevity in the business.
Optionetics Platinum Pro providers users with trade management, risk management and overall trading plan tools to help the trader successfully implement their plan. The other Platinum packages similarly provide a portion of the tools that can make a difference in your trading results. I don’t promote the different Optionetics courses, tools and products nearly as much as I probably should; I do regard them highly.
In July, two put diagonal calendar spreads were identified for Starbucks (SBUX) given a bearish outlook for the stock. One was labeled “low probability trade” and the other “high probability trade” based on their relative rankings using the Kelly Bet Fraction [KBF]. Figure 1 provides basic risk data for the two using results from a trade scan described in September. The long leg for each spread expired in Sep (low probability) and October (high probability).
Figure 1: SBUX Put Diagonal Calendar Low Probability & High Probability Trades (7/25/08)
Click here for larger view
According to my sample trade management approach, the low probability position was initiated using 21 spreads ($59 risk per spread), while the high probability position was initiated using 24 spreads ($82 risk per spread). So why the additional spreads for the higher risk position? Because trade management for this approach incorporated probability of profit for each trade rather than the risk-reward profile. The term “sample” is used throughout this article since you must decide what’s appropriate for your trading—the allocations and risk levels are not recommendations.
Figures 2 and 3 provide the portfolio charts for each individual position over the life of the trades. Although both trades dipped into negative territory when SBUX moved higher in mid to late August, the high probability trade spent the bulk of Sep and Oct in profitable territory. See last month’s article “Platinum Tools: Reviewing Portfolio Charts” for more details on these charts along with trade exit parameters.
Figure 2: SBUX Put Diagonal Calendar – Low Probability Portfolio Chart (7/25/08 – 9/19/08)
Figure 3: SBUX Put Diagonal Calendar – High Probability Portfolio Chart (7/25/08 – 10/18/08)
Trade Sizing
The sample trading plan allocated $50,000 portfolio for the strategy with a per trade risk level set at 2.5% of this amount ($1,250). In addition, the maximum position size is set at 5% of the total portfolio or $2,500. In this case, option trade sizes range from $1,250 – 2,500.
The actual position size is determined by the Probability of Profit [PoP] using three possible ranges:
- Low Probability (< 55% PoP)
- Normal Probability (55-75% PoP)
- Hi Probability (> 75% PoP)
Method #2 is then used in the Platinum Portfolio Tool in Profit Tools to calculate position size. Figures 4 through 6 provide some screen shots for navigating and applying the tool:
Figure 4: Navigating to the Portfolio Trade Sizing Tool
Figure 5: Portfolio Data
Figure 6: Applying the Portfolio Trade Sizing Tool
The following notes in Platinum provide additional trade size detail for the approach:
Portfolio Notes in Platinum:
Method 2: Max Risk predetermined at 2.5% of portfolio = $1,250
LowProb (less than 55% PoP)
Allowable Position Size = Acceptable Max Risk = $1250
Risk per Spread = $59
$1250 Allowable Position Size / $59 Risk per Spread = 21.19 spreads = 21 spreads
NormProb (55-75% PoP)
Allowable Position Size = Total Max Risk / 60% = $2083
Risk per Spread = $82
$2083 Allowable Position Size / $82 Risk per Spread = 25.4 spreads = 24 spreads (commissions)
HiProb (greater than 75% PoP)
Allowable Position Size = Total Max Risk / 50% = $2500 = Max Position Size
So KBF was used to rank the potential trades and PoP was used for trade sizing. In general, trades with a PoP less than 55% are not taken. So not only can the probability features in Platinum be used to rank and qualify trades, it can also be used for money management purposes.
As always, you need to keep in mind that probabilities are not guarantees.
To access other articles written by Clare White, please click here.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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