Last updated on April 18th, 2020
I have seen a disturbing trend with many retail options traders over the last year that is holding many people back from experiencing the big growth in their accounts.
The issue has to do with not using proper risk management in their trading.
A common approach to risk management that is taught by many instructors is to keep your risk at 2% of your account per trade.
I see many options traders throwing this rule out the window and making one of 2 mistakes:
1. They either risk way more than 2% on a trade hoping to just hit it big on a handful of trades which could change the whole ball game for them
2. They decide to trade a single contract on every trade that they take in an attempt at keeping the risk as small as possible
Both of these mistakes can lead to massive issues when trying to grow your account.
Let’s tackle the issue of trading too big of size first.
Mistake #1: Trading Positions Too Big For Your Account
While the temptation of going for the big winner can be hard to resist, it can be a recipe for disaster.
I see too many traders risking 20-25% of their account on a single trade.
When you do this you are essentially buying a lotto ticket and hoping that one or two winners will change everything going forward. Essentially your trading becomes a roll of the dice at that point.
In reality, with that approach, your account is potentially wiped out after just a few losing trades.
As a trader you will have winners, losers, and break even trades. None of us know ahead of time which trades are going to win and which ones are going to lose.
The successful traders long term are the ones that learn to keep their risk small on every trade knowing that if they do, it will be easier to put the odds in their favor long term.
Solution? More Trades + Less Risk Per Trade
Instead of risking a larger amount of capital on one or two big trades, I would much rather see a trader risk a small amount of capital on 6-8 trades. This will allow you to get your sample set of trades big enough to take advantage of the odds that options trading can put in your favor.
It also allows you to add in layers of diversification into your trading.
You can use a bigger range of different options strategies that benefit from different types of market conditions. You can also gain access to wider range of different market sectors.
All of this will lead to more consistent returns from your trading.
Mistake #2: Trading A Single Options Contract On Every Trade
On the flip side, trying to keep the risk small by trading a single contract on every trade can lead to just as many issues as trading too big on every trade.
The problem with this approach is that the value of the options will vary depending on the stocks that you are trading.
For example, trading 1 contract on Apple is not equal to trading 1 contract on Bank of America. If you do so, Apple will dominate your P/L.
One losing trade on Apple could wipe out a number of winners on Bank of America.
We highly recommend our traders risk a set dollar amount per trade. It could be $200 or $2000 per trade.
The dollar amount doesn’t matter as long as you stay consistent with it on each trade. This could mean you are trading 5 contracts on Apple and 20 contracts on Bank of America.
In doing so, you will find much better consistency with your results.
Keeping the risk similar across all trades will prevent one or two names from having too big of an impact on your results. It will also prevent the emotional aspect of trading from creeping in too much.
Knowing that each of your trades is risking the same amount of capital, will prevent you from falling in love with one or two trades. Your focus will shift to getting as many trades on as possible using small position sizes.
Trading a similar dollar amount on every trade is the single biggest breakthrough for many of our newer traders.
Keeping the risk small so you can take a larger number of smaller trades instead of one or two big trades is the key to successful trading in today’s markets where we don’t know where the next big mover is going to come from.
Risk Management Template
Here is a Risk Management template which I use in my own personal trading that will help improve your results immediately.
Keep in mind this is the outline that I use personally.
I put in some sample numbers so you can see the whole picture. Make sure you adjust the numbers to fit your specific account size and risk tolerance.
1. Risk no more than 50% of the account size at any one time. This is 50% of the account spread across many different positions. For example, if you have a $10,000 account don’t have more than $5,000 at work in trades at any one time.
2. Risk $500 per trade. This could mean I’m trading 5 contracts on some trades and 10 contracts on others. In doing so I will see more consistent returns from my trading. Keep in mind this number could be different for everyone depending on account size and risk tolerance. We like to keep this number at 3-5% of your account size per trade.
3. Make sure I’m using a mix of long calls and puts, debit spreads, and credit spreads. In doing so, it will add in another layer of diversification. This will allow me to spread my risk into many different areas and will give me the ability to position myself for many different market conditions.
I see many retails traders spending all their time and thousands of dollars looking for the magic indicator or system that is going to give them the big returns with zero risk.
In reality, the key to profitable trading is controlling the risk.
It’s not a fun topic that will get will get you excited about the markets but it’s the missing piece to the puzzle for so many traders.
If you take the time to follow the outline above you will be amazed at how quickly your results will improve.