Options trading can be a great way to make money, but it comes with its own set of risks and rewards. Options trading is not for everyone, but for those who are willing to take the risks, it can be a profitable venture.
Options Trading Risk
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Like any other investment, options trading carries its own set of risks. Here are some of the risks associated with options trading:
- Limited Timeframe – Options have a limited timeframe, typically ranging from a few weeks to a few months. This means that if you don’t make the right move within the given timeframe, you could lose your investment.
- High Volatility – Options trading can be very volatile. This means that the price of the underlying asset can fluctuate rapidly, making it difficult to predict the outcome of your trade.
- High Risk – Options trading is considered a high-risk investment. This is because the price of the underlying asset can fluctuate rapidly, and the value of the option can decrease quickly.
Options Trading Reward
Options trading can be a very rewarding venture if done correctly. Here are some of the rewards associated with options trading:
- High Returns – Options trading has the potential for high returns. This is because options trading allows you to leverage your investment, meaning you can control a larger amount of the underlying asset with a smaller investment.
- Flexibility – Options trading offers flexibility in terms of the underlying asset you can trade. You can trade options on stocks, commodities, currencies, and more.
- Hedging – Options trading can be used as a hedging strategy. This means that you can use options to offset losses in other investments.
The Importance of Effective Money Management
Money management is only included in the trading plan by about one-tenth of all private traders. Just because a trader does not have a lot of capital does not mean that he cannot apply the principles of money management. Many traders are of the opinion that these ideas can only be used by large asset managers and institutions.
Money management also implies that the potential risk, taking into account the preferences of the trader, is set in relation to the expected profit. The goal is to set a desirable yield rate and then minimize the associated risk.
Trading generally requires four decisions:
- Buy/sell (system or strategy)?
- Which security is traded?
- How many contracts or shares of value are traded?
- What is the share of capital risked on a trade?
The first decision is about the trading process itself without taking into account money management. The other three decisions involve maximizing profit and minimizing risk directly. The foundations of risk and reward should be considered from the start in the development of a trading system and must become an integral part of the system.
If a trader works profitably right from the start and has thus increased his trading capital, then he cannot be ruined by four losses (as long as his bet remains the same). Although the number of consecutive losses that would lead to ruin increases with time, so does the likelihood of multiple losses follow one another. The following formula calculates the probability of ultimate ruin (WR) over time:
WR = (1-VT / 1 + VT) AH
VT stands for the trader’s advantage (percentage winners – percent losers), and AH is the initial trading units. If the initial capital of a trader is $ 20,000 and his bet per trade is $ 5,000 then AH = 4. The following example calculates the probability of ultimate ruin:
Total Capital§ 20,000 Total Capital$ 20,000
Deployment$ 5,000 Deployment§ 2,500
Advantage of the Trade10% Trades’ Advantage10%
Chance of Ruin44.8% Chance of Ruin20.1%
Total Capital$ 20,000 Total Capital$ 20,000
Bet$ 2,000 Bet$ 1,000
Advantage of the Trade10% Advantage of the Trade10%
Chance of Ruin13.4% Chance of Ruin1.8%
These numbers apply only when you trade one contract at a time. With changing contract numbers, the risk of ruin changes dramatically. Moreover, these calculations assume that, in the case of a profit, the amount is always the same and corresponds to the loss in the negative case. As mentioned above, the risk of ruin is determined by the percentage of winners, the ratio between winners and losers, and the size of the bet. So far, we have disregarded the relationship between winners and losers. In real life, most successful trading systems score less than 50% winners and win-loss ratios above 1.2.
The risk of ruin is an interesting indicator, but it does not give much insight into how to use or manage capital efficiently. For self-preservation, it is best not to put everything on one card. If you choose your bets well and follow a system with a positive bias, the risk of ruin is very low.
The Capital Allocation Model
Now you know the tools you need to understand our capital allocation model. First, we’ll show how capital is allocated to a one-market portfolio using a small selection of data.
As you know, our goal is to maximize profit while minimizing risk. This goal must be achieved without exceeding the limits of justifiable risk. To reach the goal, we need to know how much capital is to be allocated to each market and what number of contracts should be traded. In this model, capital is calculated from the market value of the account, the average monthly returns, and the market risk. The market value is simply the starting capital with which we begin our trading. In these examples, the returns do not add up; we use the initial capital for all calculations. The average monthly income is the capital that we can expect to gain from our system. Market risk is the amount we can lose per day on a trade. Asset managers use a variety of metrics to assess market risk:
• Mean Range: The average of the ranges of the last three to 50 Days, which is converted into a monetary amount in US $. For example, if the average spread is 40 points for the Swiss franc over the past 10 days and the Swiss franc is $ 12.50, the market risk is $ 500. The likely amount of market movement is the average spread of the last x days. This does not always have to be right, but the capital allocation model needs to be built on certain probabilities.
• The average change in closing prices: The average change in closing prices over the last three to 50 days says more about the risk, as this value indicates the expected risk if the position is held.
• Mean change in positive closing prices versus negative closing prices: the average change in the negative closing prices over a period suggests the risk of holding a long position.
• The standard deviation of closing prices: The standard deviation of the closing prices gives a more accurate picture of the risk, as the daily deviation is displayed with a probability of 68%. This calculation is a bit more complex, but it does not cause any problems with the computers available today.
In whatever way we measure the risk, it is the most important variable to watch and the most important component of the capital allocation model.
A Market Portfolio
Whether the system trades futures or stocks makes no difference. Before we can allocate capital, the average monthly income and market risk must be determined on the basis of a contract. We also need to determine how much of our capital we are willing to risk per trade. But we cannot know that yet, because that’s exactly what we want to find out.
Cumulating Of Results
Cumulating means here the process of capital allocation based on the current portfolio or deposit value. The current portfolio value results from the start-up capital as well as the already completed positive and negative trades. When it comes to large sums of money, accumulation is very good: the capital invested increases or decreases depending on the current value of the deposit. If a trading plan is successful, then each trade will be given more capital; but if it is bad, then there is less capital available for each trade. Note that we have found that cumulating is very good when it comes to large sums. This limitation stems from the belief that the allocation should not be extended until the seed capital of smaller accounts has not been at least doubled or tripled. Even good systems can crash after a series of wins, and if a smaller account does not cumulate, there is still some capital left for bad times. If accumulation is of interest to you (and it should, if you have significant sums of money), then you can build it into the capital allocation model with a small change. In the formula, do not use seed capital as total capital (GK), but use the current value of the deposit.