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Averaging In: Part One

Dividing your pre-set risk capital for any trade into three equal dollar amounts is a simple task. A more difficult personal task is predetermining, before any options trade is taken, how many positions you want open at a given time. The other important and predetermined decision will be how much of your total capital will be allotted to your options trading portfolio.

Those two decisions are made so that you will be in complete control of your risk. In order to have that control you must take a personal vow of sorts to always trade with positive gamma.

When you decide to take just one options trade with negative gamma, you have invited Pandora into the calculus of the risk. Do not invite Pandora into that calculus. Trade options with positive gamma only. Break this personal vow and you have no concrete predetermination as to your actual dollar risk. Breaking this vow allows unknown and unexpected outlier events to become part of the risk and logically takes risk to an unknown level. Trading using the averaging in method does not allow for unknown predetermined risk.

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How many options positions to have open at any one time makes for a good debate. That number for me is eight. If you trade less than eight, you invite capital account balance volatility, i.e., big swings in your capital account balances. More than eight positions tends to have the opposite effect as small swings in your capital account will be the norm as will small capital account balance movement. In other words, the more positions you have on, the higher the probability for less return on your risked capital.

It makes for good risk management sense to almost always have 20% of an options trading account in cash. Having cash on hand to take advantage of changes is a wise predetermined tactic.

With eight positions and 20% cash making up this options trading portfolio, you can now begin to predetermine the capital that will be used for your next trade. For example, if your option trading capital account is funded with $25,000, 20% of the account is $5000 which is kept in cash at most times, and used if an opportunity occurs. Should you become 100% positioned having used that cash on hand, it is best to select one or more open trades to close when the timing makes sense. You do that to get back into the 20% cash on hand position.

The $20,000 that is the 80% of the capital account should be divided by eight. Thus $2500 would be the limit for the eight open trades that over time will make up the core positions of the option trading account. (Of course you might determine that six open trades are prudent at that time. Whatever your decision my averaging in method will have you divide the trade capital into equal dollar amounts).

That $2500 should now be divided into three parts, or $800+ for each part. This amount, the $800+ makes up the capital that is to be used to execute the first trade of what will eventually be three separate trades. The average price of these three trades will be the cost basis for the trade. Once all three have been risked, no other funds should be added to that one trade.

The percentage parameters/targets relative to any gain or loss for a trade is a personal decision. Mull these parameters over extensively and prudently. Once determined however it is best to give them time to prove their efficacy or lack of. We are all different, and thus I cannot speak to what will be your own personal risk and reward parameters. That is for you to decide. When to take a gain or a loss is a combination of prudence as well as the art of the trade.

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