Get a firm grasp on the key concepts behind options trading money management
[Editor's note: The idea of long losing streaks may seem abhorrent to you as a trader, but the number crunchers at Schaeffer's Investment Research have mathematically shown that you can make money with more losers than winners. Dealing with several losers in a row can be a psychological challenge, but if you have confidence in the trading strategy, discipline and follow-through can be keys to profitability. While you've all probably heard the old market adage "let your winners ride and cut your losses short," Schaeffer's again mathematically proves this is a critical function of money management, which is necessary for success in trading. Additionally, the amount of money you invest in each trade must be carefully determined. Limiting your capital allocations per trade can ensure that you will stay in the game and will help you ride another day, even through those inevitable losing periods.]
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More than ever, in this modern age of investing that involves aggressive strategies such as options and single-stock futures, the tenet of money management is one of the most important, yet most ignored, considerations in investment success. However, the principles of money management, particularly in relation to options trading, cannot begin to be mastered without a firm grasp of the statistical probabilities involved. In his esteemed book, Trading for a Living, Dr. Alexander Elder sums up the importance of this concept in a word - innumeracy. According to Elder, "Innumeracy - not knowing the basic notions of probability, chance, and randomness - is a fatal intellectual weakness in traders."
Renowned investing and trading coach Dr. Van K. Tharp addressed the issue of winning percentages in the November 1997 issue of "Technically Speaking," the newsletter of the Market Technicians Association. In his article, "Why It's So Difficult for Most People to Make Money in the Market," Tharp states:
"Most of us grew up exposed to an educational system that brainwashes us with the idea that you have to get 94-95 percent correct to be excellent. And if you can't get at least 70 percent correct you're a failure. Mistakes are severely punished in the school system by ridicule and poor grades, yet it is only through mistakes that human beings learn. Contrast that with the real world in which a .300 hitter in baseball gets paid millions. In fact, in the everyday world few people are close to perfect and most of us who do well are probably right less than half the time. Indeed, people have made millions on trading systems with reliabilities around 40 percent."
It should be noted that Dr. Tharp is not specifically referring to options trading in his discussion of winning percentages. In fact, you should expect winning percentages for option premium buying to be lower than that for trading stocks or futures. Our research shows that successful short-term options traders are correct on roughly 35 to 40 percent of their trades.
Although this win rate may seem rather low, there are factors such as fighting time decay and preserving capital by shutting down losing trades beyond a certain point (some of which may ultimately have been winners) that are particularly relevant to options trading. The important point is that positive overall returns over the longer haul result from allowing your profitable trades to run and cutting your losses in other trades relatively quickly.
The concept of limiting losses and letting the winners run cannot be overstated. In his classic work, The Battle for Investment Survival, Gerald Loeb states, "Accepting losses is the most important single investment device to ensure safety of capital. It is also the action that most people know the least about and that they are least liable to execute ... The most important single thing I learned is that accepting losses promptly is the first key to success." In addition, Loeb says, "The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize on successes and curtail failures."
Our trading goals follow these principles in that we strive to maintain a winning percentage of between 30 and 40 percent in our options buying programs. At the same time, we manage our recommendations such that our winning trades gain far more than our non-winning trades lose. For example, our aggressive Players Series, which consisted of five trading services, had an overall 42-percent winning percentage in 2001 (66 winners and 91 losers). Despite succeeding less than half of the time, these services managed a combined return of 40 percent on a portfolio basis. How did this series manage to achieve such impressive results? - by averaging 111 percent for each winning trade (letting winners run), while keeping the average loss at minus 55 percent (cutting losses short).
An offshoot of this lower winning percentage and something that often comes as a surprise to many traders is the experience of coping with an extended losing streak. The ultimate goal of achieving profitability will remain out of reach unless great care is taken to control the amount of capital allocated to each position, as even wildly successful traders are not immune to a string of losing positions. In short, the objective in options trading is to "stay in the game" through proper money management techniques that allow you to weather the inevitable storms of losing trades.
To shed some mathematical light on the importance of proper money management, our quantitative analysis group created the following table that displays the likelihood of experiencing losing streaks of various lengths based on a range of win rates.
Chart 1: Probability of seeing at least X consecutive losing trades
The numbers in Chart 1 are based on a 50-trade period, or roughly four options trades per month for one year. The "Win Percentage" column encompasses a wide range of potential win rates, from five to 95 percent. The table shows the probabilities of seeing anywhere from two to 11 consecutive losing trades during the 50-trade cycle, based on the corresponding percentage win rate.
The table can help you determine the probability of a pronounced losing streak. For example, if your expected winning percentage (over a similar 50-trade period) is 40 percent, the odds of seeing a losing streak as long as eight trades during a 50-trade period is 51.7 percent (see the bolded box).
For a 30-percent win rate, the probability of experiencing five straight losing trades at some point during a 50-trade cycle is essentially 100 percent. An extremely successful options service is one that has a 40-percent win rate. Such a service still runs a 97.6-percent chance of enduring a string of five consecutive losing positions. Also note that a strong winning percentage of 40 percent will stand a better-than-50/50 chance of seeing eight consecutive losses over a 50-trade period. Thus, given the high probability (and in some cases, certainty) of losing streaks within a given period, it is critical to realize that investors who place too much capital into successive recommendations run the risk of decimating their trading account during a perfectly normal trading cycle. In other words, they will be unable to stay in the game. Those that are able to stay in the game, thereby reaping the rewards of the hot streaks and higher returns of winning trades, stand a better chance of ultimate profitability over the longer haul.
Going back to our previous example, one of the Players Series' five services had a track record that illustrates 1) losing streaks will occur and are virtually inevitable, and 2) it is possible with proper capital allocations to not only overcome these losses but to achieve profitability. This particular service was very active in 2001, logging 45 trades over the year. The service's winning percentage was 46 percent (21 winners), the average win and loss returns were 114 and minus 55 percent, respectively, and the portfolio return was 110 percent for the year.
The most interesting number, however, is that this service experienced seven losing trades in a row, yet still managed to profit handsomely. We should point out that such a losing streak is not an unusual event. In fact, the likelihood of a 10-loss string with a 32-percent win rate is 58 percent, greater than the probability of a coin flip in either given direction. The moral of the story is that even though low winning percentages and long losing streaks are part of the options buying game, profitability is achievable if you let winners run and cut losses short while staying in the game by using proper money management principles.
So, not only is it crucial that you implement sound money-management practices, it is also important that you understand and accept that there will be losing streaks (as well as winning streaks!) along the way. A losing streak does not signify that your approach is defective, nor will a winning streak imply invincibility. These streaks are simply part of what to expect along the way to achieving a profit from the "positive expectancy" of your trading. This principle will be covered in the next section.
Another critical factor on which Tharp adds advice is what he defines as a "positive expectancy" system. By this, he means that over a large number of trades, you should expect to achieve a positive return for each dollar risked.
For example, in a long run, an even bet on "heads" in the flip of a standard coin yields a "zero" expectancy. This is based on two key facts; the probability of profit is an even 50 percent, and the payoff for "heads" is equal to the loss when "tails" is flipped. The formula for this zero expectancy is:
[(50 percent)(1.00)] + [(50 percent)(-1.00)] = 0 percent
A positive expectancy for this bet would occur if the coin were not standard, but if it were weighted so that the probability of "heads" was 60 percent. In this case, the positive expectancy would be 20 cents for each dollar bet, as illustrated by the following formula:
[(60 percent)(1.00)] + [(40 percent)(-1.00)] = 20 percent
Another way to achieve a positive expectancy is for the payoff for a win to exceed the penalty for a loss. If you were paid $1.20 for each "head" that was flipped but lost only $1.00 when "tails" came up, your positive expectancy would be figured as 10 cents for each dollar bet:
[(50 percent)(1.20)] + [(50 percent)(-1.00)] = 10 percent
The Expectational Analysis® trading approach employed at Schaeffer's Investment Research demonstrates Tharp's positive expectancy theory with each trade recommendation. This is exemplified by the earlier Players Series example, where the average winning trade (of 66 trades) enjoyed profits of 111 percent, while the average losing trade (of 91 trades) dropped only 55 percent. This yields a positive expectancy of 14.7 cents for each dollar invested as calculated below:
[(42 percent)(111 percent)] + [(58 percent)(-55 percent)] = 14.7 percent
One of the primary advantages of the fixed fractional bet system detailed above is the principle of convexity - playing more dollars on the way up, while risking fewer dollars after each losing trade. When trades are moving against you, this system keeps you in the game longer by allowing you to weather the losing streaks that, as proven earlier, will inevitably occur. For example, if you begin with a portfolio of $25,000 but continue to risk a fixed amount of $2,500 with every losing trade, you will lose half your bankroll ($12,500) if you endure 10 consecutive losing trades of 50 percent a piece.
Chart 2: How Convexity Aids a Losing Streak,
While it is unlikely that you will suffer such a streak right off the bat, it is certainly not outside the realm of possibility. The fixed fractional system presents quite a different outcome. In fact, this approach comes out $2,468, or nearly 20 percent, ahead of the fixed investment approach, as shown in Chart 2.
On the plus side, let's assume you enjoy five straight winning trades of 100 percent each. Investing an even $2,500 per trade will result in a portfolio balance of $37,500. On the other hand, the fixed fractional bet system yields a return of $40,263, or 7.3 percent better, as shown in Chart 3.
Chart 3: How Convexity Impacts a Winning Streak
Our goal in advocating solid money management principles is to provide a deeper understanding of some of the mathematical probabilities associated with trading options. We hope that you will reevaluate the total dollar amount invested in every recommendation by examining whether you can withstand a string of losing trades that will inevitably occur over a certain number of trades. An analysis of your own situation may reveal that your current trade allocations will not hinder your ability to profit over the long haul. However, if you determine that your current allocation would not allow you to withstand a losing streak, then we recommend that you either reduce the total dollar amount allocated to each trade or increase the size of your option-trading account. Ultimately, we are confident that you stand a better chance of profitability if you do your part in terms of responsible money management. In our view, it will be in your best interest to have the long-term staying power to reap the full benefits of short-term options trading.
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