The main goal with options trading, or any method of investing for that matter, should be to never lose money.
Sure some trades don’t pan out, but over the long run, you should be making money with options trading not burning it.
For most of us money is a finite resource, and you don’t want it going to zero.
The easiest way to avoid this is by having a tight control over your bankroll….aka the amount of funds you have available to invest with.
What is Variance in Options Trading?
To understand why bankroll management is important, we need to first explore variance.
Variance is the difference between how much money you expect to make on average over the long run based on historical data and the actual results you see in the short term.
Put more simply, it’s the down and up swings involved with trading.
It’s guaranteed you won’t profit off every single trade you make.
However, over a long enough time frame your actual results should meet up with your expected results if you’re a profitable trader. In the short term the amount that you make or lose across your entire portfolio is variance
Why is Variance Important?
The reason variance is such an important concept to understand in options trading is because “short term” is not a defined timeframe.
A downswing could be a day, week, month…..or until your account goes to zero.
That last one is the result we want to inevitably avoid.
If you do hit an unusually long down swing, proper bankroll management will minimize the risk of your account dwindling away to zero.
Two Strategies for New Traders
There are two primary components of bankroll management for options trading.
- Diversification of Positions
- Position Sizing
Diversification of Positions
Diversification is a common theme regardless of your particular investment strategy, so it makes sense it would indeed apply to options trading.
The basic principle is that diversifying across multiple investments, companies, sectors will create a balanced portfolio and minimize the risk of one bad investment wiping out your entire account.
That means no YOLO’s
If you want to win over the long run, it’s smart to not go all-in every single time. Especially in volatile markets when even a simple tweet can shift market sentiment.
Easiest way to offset risk in the scenarios is by trading different, non-correlated types of companies, sectors, ETFs. You have the potential to profit in a few different ways and aren’t dependent on any single outcome.
The second rule for bankroll management in options trading is position sizing, or deciding what percentage of your total account you want to use for any particular position.
There’s no golden rule on what the optimal percentage is. I know some traders who stick to no trade over 2% of their account while others are completely fine being in the 5% range.
So for example, let’s break down a $3,000 account.
2% = $60
5% = $150
1% = $300
As you can see, your position size could be radically different for the same total account value, it just depends on your personal risk tolerance.
The reason this is critical is because following a strict limit slides your position size up and down based on your account value.
Lets say your total account value is $3,000 and your preferred position sizes are 5% or $150.
You hit an unexpected downswing and your new account value is $2,000.
What happens to your position size? Well, it goes down. Your 5% threshold now equates to $100 per position.
This allows you to maintain the same level of risk tolerance regardless of how your account value fluctuates.
Overall, it’s extremely easy to lose money with options trading. As a first step, your main goal should be to avoid going broke. Proper bankroll management will help you achieve just that.