Depending on their trading styles and risk tolerance, traders can select among a number of money management approaches for options trading; these will dictate how much to invest (and reinvest) in a given trade. Below, we outline three such strategies and show their benefits as well as potential drawbacks.
One of the most popular money management strategies involves the reinvestment of both the principal and profits after each (positive) trade. For instance, if a trader allocates $2,000 to a first trade and then makes a 50% profit, he/she would be able to invest $3,000 in the following trade (the principal of $2,000 plus the $1,000 profit). By investing in this fashion, a trader will benefit from the power of compounding; however, trading options this way is aggressive and very risky - a trader could quickly wipe out an entire portfolio. It is not recommend approach for options trading!
Another popular money management strategy is to allocate a fixed percentage of the portfolio to each trade. For instance, a trader may decide to invest 20% of a portfolio in each trade. Assuming a $10,000 portfolio, the trader would thus invest $2,000 per trade. Should a trade result in a 50% profit, the trader would then have $11,000. He or she could then allocate $2,200 (20% of $11,000) for the next trade. This approach to options trading is considered conservative.
A third way to allocate funds is to invest a fixed amount per trade. For instance, a trader with a $10,000 portfolio could set aside $2,000 for each options trade. Even if a trade resulted in a 50% profit, the trader would still only invest $2,000 in the next trade. This strategy is less profitable than strategy 2 discussed above; however, it allows a trader to recover more quickly from (a) losing trade(s). In order to increase their profit potential in good times, traders sometimes combine this approach with a higher investment once a certain portfolio size has been reached. For instance, a trader may decide to invest $3,000 per trade once his or her portfolio has grown to $15,000.
The comparison table below shows how a portfolio would fare using the three money management strategies discussed above. The following assumptions are made:
| Strategy #1 (reinvest everything) | |||
| Invested into a trade | Profit from a trade | Total Profit | |
| Initial Portfolio Value | $10,000 | ||
| 1st Trade: -70% | $10,000 | -$7,000 | -$7,000 |
| 2nd Trade: +50% | $3,000 | +$1,500 | -$5,500 |
| 3rd Trade: +50% | $4,500 | +$2,250 | -$3,250 |
| Portfolio at the end | $6,750 (33% loss) | ||
| Notes | A very aggressive and highly risky strategy. The trader risks losing the entire options portfolio with one bad trade, making it very difficult to recover. | ||
| Recommendation | Not recommended for options trading | ||
| Strategy #2 (reinvest 20% of the portfolio) | |||
| Invested into a trade | Profit from a trade | Total profit | |
| Initial Portfolio Value | $10,000 | ||
| 1st Trade: -70% | $2,000 | -$1,400 | -$1,400 |
| 2nd Trade: +50% | $1,720 | +$860 | -$540 |
| 3rd Trade: +50% | $1,8922 | +$946 | +$406 |
| Portfolio at the end | $10,406 (4% profit) | ||
| Notes | A conservative strategy. While it may also be difficult to recover from losing trades, a recovery is often much faster than in strategy #1. This strategy has some compounding effects. The risk of losing the entire options portfolio is relatively small. | ||
| Recommendation | Recommended for options trading. | ||
| Strategy #3 (invest $2,000 per trade) | |||
| Invested into a trade | Profit from a trade | Total profit | |
| Initial Portfolio Value | $10,000 | ||
| 1st Trade: -70% | $2,000 | -$1,400 | -$1,400 |
| 2nd Trade: +50% | $2,000 | +$1,000 | -$400 |
| 3rd Trade: +50% | $2,0000 | +$1,000 | +$600 |
| Portfolio at the end | $10,600 (6% profit) | ||
| Notes | A conservative strategy. Recovering from losing trades is comparatively easy. This strategy has no compounding effects. If several significant losses in a row are sustained, the strategy could still result in a total loss of one's options portfolio. | ||
| Recommendation | Recommended for options trading. | ||
The key strategy to protecting your profits is always allocating a predetermined and fixed amount (principal) of your trading capital to options trading. There is no trading system in the world that can guarantee a 100% success rate. You will likely experience a negative trade, i.e., a trade where you lose all the money you invested sooner or later.
Reinvest only the original trade principal, following a winning options trade, never the principal plus the profit! If your trade allocation for options is $1000 for instance, and a previous trade provided you with a $500 profit, we strongly advise against reinvesting the full $1500 into your next options trade. We suggest applying only the original $1000. Should you have a (total) loss due to an option expiring worthless, this way you would still have $500, your profit from the previous trade.
Particularly tempting market situations can arise, periodically, which may entice you to commit more of you trading capital to options than originally allocated. A few situations that might persuade you to abandon discipline are:
Don't be tempted to break the rules under these or similar circumstances! Never exceed the predetermined amount you allocated to options trading.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.