The importance of Capital Allocation
Traders want to be in the game for always. They don’t want to take to much risk that can hurt them. Proper Capital Allocation is very important. It is the process of how you divide your money on cash, stock and options. You might even have a fix amount of money for each strategy.
A trader who sells option premium wants to build up a good portfolio. When selling options you want to have a balanced portfolio, and enter trades on with equal risks. The question then rises: “How much capital should you allocate for each trade?”
Definition of Capital Allocation
Everybody has an amount of money to trade with. Some has more money than other. Regardless the size of your account, how do you decide how much money to use for each trade? A good approach is to roughly allocate the same amount of capital for each trade. Any trade requires a certain amount of money. It is called margin or capital requirement. It is a number that correspondents with the risk of a trade.
When thinking of capital allocation You may want to see a good Return of Investment. You have a goal per trade, for example $200. You pick a strategy to trade your options. For instance you choose a spread that requires $50 of capital. You could trade 4 of these spreads The total capital requirement of this trade is $200.
Allocate small capital for bigger number of success
Imagine we are playing at a basketball court. I’ll give you $100 when you when you score 10 times at a row. Or you can choose to through the ball 10 times and I’ll give you $10 for each time you score. If you are decent in scoring than you choose to make the 10 smaller shots that reduces the effect of an unlucky bounce can have on the unlucky outcome.
Trading in small positions has the same benefit on your portfolio. The ideas behind this approach is that if each of your trade uses the same strategic logic. It makes sense that you allocate each trade the same amount of money.
The moral of this story is: trading in smaller equal sized chunks can help you to make a more successful trader. How much capital should you allocate for each trade then?
Why is Capital Allocation Extremely Important
You should only ever risk a certain percentage of your capital on any one trade/position. We suggest to limit your risk to maximum of 3%. If you are a beginning trader use not more than 3% because it allows you 33 consecutive loosing trades before you blow your account so you have plenty of time to maneuver and you don’t become emotionally attached to any single trade or position. So for each instrument your Maximum $ Risk Per Trade is 3% x Capital Allocation, in this example, 3% x $2,500 = $75 is the maximum amount you should risk on each allocated position.
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Of course you want to sell options and count on entering trades with a high win rate. A High Probability of Profit so to say. But all traders experiences losses. In a bad time you might experience several losing trades at a row. If your trade size is small enough it doesn’t bother to much. You might even lose 10 trades at a row and it doesn’t harm you. You definitely want to trade small and trade often.
Experienced traders do know how important Capital Allocation is. It is the difference of being in the game over a number of years or not. Having a healthy portfolio with a high return of investment or not.
I hope this post is relevant for you. That you’ll have more insight in capital allocation. You also might like to read how to be successful at options trading.