I’ve read a few option books.
THANKS... This is probably the most comprehensive "greeks" article/book I’ve read.

Wonderful blog. …..
A wonder wealth of knowledge there. Thanks so much for your kindness in publishing it!

Thank you very much for the most concise and simplest option intro. Highly recommended.

So far, yours is the best blog/site on basic options notes in the web that I have chanced upon.

Monday, December 21, 2020

Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

In setting money management/position sizing rules, you should also consider:

1) How long your capital can last, or

2) How long your account balance will drop to the risk tolerance you’re willing to take after going through a series of successive losing steaks.

The answers to these questions will depend on:

* The initial capital/account balance

* How much to risk per trade

* The percentage risk tolerance (for Qtn 2)

 

Suppose your initial capital is $10,000.

If you money management rule is that you would risk maximum 5% of the initial capital (i.e. 5% x $10,000 = $500) in each trade, your capital will be all wiped out after 20 successive losing trades.

Suppose your risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), your balance will reach this level after 5 losing trades in a row.

Notice that the above rule is different from what has been discussed as Option 2 in the previous article.

In the Option 2, the maximum risk in each trade is 5% of the remaining account balance.

Hence, with the initial capital of $10,000, after losing 5% (i.e. 5% x $10,000 = $500) in the 1st trade, the balance will be $9,500. Then, the 2nd trade will risk 5% of the remaining balance (i.e. 5% x $9,500 = $475), the balance will be $9,025, and so on.

Using this rule, to answer the above questions is not that straightforward. However, this rule is more common to be used by traders.

Hence, let’s try to formulate it.

Trade 1:  $10,000 x (1 – 5%) = $9,500

Trade 2: $10,000 x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^2 = $9,025

Trade 3: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) = $10,000 x (1 – 5%)^3 = $8,573.75

Trade n: $10,000 x (1 – 5%) x (1 – 5%) x (1 – 5%) x …… = $10,000 x (1 – 5%)^n

Putting in a formula form:



Where:

C = Initial capital (Initial account balance)

R = % Risk for each trade

n = Number of trades

B = Remaining capital/account balance

To answer the above two questions, we need to solve n, which can be done through the basic principles of logarithm, as follows:





Please note that, to answer Qtn 1, we CANNOT set the remaining account balance as zero, as logarithm function will never touch zero line. Hence, we should assume a certain amount, which is small enough and can be deemed as “no more money for trading”.

For example:

Assume we deem $100 as small enough to approach a situation of “no more money for trading”.

Continue with the above case, the values of each variable are:

C = $10,000

R = 5%

B = $100

To find how long the capital can last, we solve n:



Note: Always round down the result.

Likewise, to answer Qtn 2 where the risk tolerance is 25% (i.e. 25% x $10,000 = $2,500), the values of each variable will be:

C = $10,000

R = 5%

B = $10,000 - $2,500 = $7,500

Solving n:




Alternatively, we can also use another method to answer the questions, which is using Tabulation, as what has been done in the previous article:


Using this way, after inputting the formula in MS Excel accordingly, we just need to “drag the row” to copy the formula until we reach the desired account balance.

From the above table, the answer for Qtn 1 is highlighted in yellow, whereas the answer for Qtn 2 is in green.

For reference, the following are the formula used for both methods:



Go back to: Things To Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

To view the list of all the series on this topic, please refer to: Money Management / Position Sizing


Related Topics: 

Thursday, February 5, 2015

Things to Consider in Setting Money Management Rules – Part 2: RISK TOLERANCE

In setting a suitable money management, you should also consider the maximum drawdown you are willing to accept, which depend on your risk tolerance.
In this case, do take into account the reasonable percent return required to recover to breakeven when you experience a certain percent of losses (drawdown), as discussed in the previous post.
Then, set money management rules based on your risk tolerance (expressed in terms of percentage of the total account/capital).

Just a simple example:
If you are willing to suffer from losses of maximum of 25% of your total capital, this means your risk tolerance is minus 25%. In this case, you should set money management rules and/or choose trading strategy that has a maximum drawdown statistics of 25% or less.

Consider two options of the following money management rules:
Option 1: Maximum of 2% risk (of the remaining account balance) in each trade
Option 2: Maximum of 5% risk (of the remaining account balance) in each trade



As can be seen from the above table, using Option 1 (max 2% risk for each trade), your account will drop to a level that is close to your risk tolerance of maximum 25% drawdown only after 14 consecutive losing trades.
In contrast, using Option 2 (max 5% risk for each trade), your account will even exceed that level only after 6 losing trades in a row.

Looking at another perspective, Option 1 will suffer 26.1% loss in the case of 15 consecutive losing trades, which would require 35.4% gain in order to be back to breakeven.
On the other hand, with the same scenario of 15 successive losing trades, Option 2 suffers 53.7% drawdown and will need 115.8% gain, which is much harder to achieve, to be breakeven. Although losing 15 times in a row is quite an extreme case, in reality it is still possible to happen.

Remember that although you might have implemented strict money management rules, losing streaks and drawdowns are inevitable.
Hence, you should set a sound money management strategy that aims to avoid risk of ruin at all cost, can survive a period of losing streaks, and also still reasonable to rebound to at least break even.

Continue to: Things to Consider in Setting Money Management Rules – Part 3: HOW LONG YOUR CAPITAL CAN LAST

Go back to: Things To Consider in Setting Money Management Rules - Part 1: DRAW DOWN

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2

Tuesday, June 17, 2014

Things to Consider in Setting Money Management Rules – Part 1: DRAW DOWN

One important part of money management/position sizing is the ability of a trader/investor to avoid large draw downs or limit the draw downs to a certain percentage of the trading capital/portfolio.
If the traders/investors always take high risk in their trades, they are more likely to experience disastrous drawdown. Therefore, the way to avoid it is by limiting the size of what you are prepared to lose / risk in any single trade to a certain percentage of your total trading capital/portfolio (i.e. proper position sizing).

A draw down is defined as a reduction in the account/portfolio from its highest point resulted from a losing trade or series of losing trades during a certain period.
A draw down is measured in terms of a percentage between a recent peak to a recent trough of the account/portfolio.
If all your trades were profitable, you will never experience a drawdown. The calculation of draw down would begin only with a losing trade, and continue so long as the account hits new lows.

With regards to drawdown, it is important to understand that the percentage return that you need to make in order to get back to breakeven is bigger than the percentage of losses you experienced.
So, if you lose 10%, you cannot gain back to breakeven by getting 10% return in the next trade, but it would be more than 10%.
For example:
Suppose your initial capital is $1000. If you lose 10% ($100), the remaining capital will be $900. If in the next trade you make 10%, your capital will only reach $990, still losing $10 (or 1% loss from the initial capital). In order to recover to breakeven, you will need to make $100/$900 = 11.1% in your next trade.

The following table shows the percent return required to recover to breakeven when you experience a certain percent of losses (drawdown).


From the table, we can see that as drawdown increases, the percent gain required to recover / get back to breakeven increases in a much faster rate.
For instance, when you lose 20%, you would need to make 25% return on the remaining capital to get back to breakeven. However, if you lose 40%, you have to gain 66.7% to breakeven.
Further, a 50% drawdown would require a 100% return, and drawdowns above 50% require huge returns in order to recover to breakeven.

From here you can see that the more you lose, the more difficult for you to make it back to your original account size. When you risk too much and lose, your chances to recover your capital fully would be very slim. It is not only because you are merely left with much less money in your account, but also you have to deal with the negative psychological impacts of the drawdowns.

Therefore, it is extremely important that you have good money management rules, so that when you experience losing streaks and suffer from drawdowns, you will still have enough money to stay in the game.
With a proper money management, you should only risk a small percentage of your account in each trade, so that you can survive your losing streaks and also avoid a disastrous drawdown in your account.

Continue to: Things To Consider in Setting Money Management Rules - Part 2: RISK TOLERANCE

Go back to: The Importance of Money Management / Position Sizing

To view the list of all the series on this topic, please refer to:
Money Management / Position Sizing

Related Topics:
* Understanding Implied Volatility (IV)
* Understanding Option Greek
* Understanding Option’s Time Value
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2