Money Management Guidelines:
Crucial in Determining Ultimate Profitability

With all the talk about how the market is doing or where it's headed, it's easy to get caught up in identifying the hot stock or sector. Adding options to the mix creates another layer of analysis - what option to pick, what strategy to use, what time frame to look at, etc. But amid all this analysis is a factor that many believe is the most important - and most ignored - consideration to investment success…proper money management.

The principles of money management in options trading cannot 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 Dr. Elder, "Innumeracy - not knowing the basic notions of probability, chance, and randomness - is a fatal intellectual weakness in traders."

You can be successful with a winning percentage of under 50 percent

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," Dr. 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% correct to be excellent. And if you can't get at least 70% 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%."

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 insure 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 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. 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 Leverage series, which consisted of four services, had an overall 39-percent winning percentage in 2000 (49 winners and 76 losers). Despite succeeding in less than four in 10 trades, these services managed a combined return of 58 percent on a portfolio basis. How did this series manage to achieve such impressive results? By averaging 71 percent for each winning trade (letting winners run), while keeping the average loss at minus 30 percent (cutting losses short).

Losing is part of the game

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.

Win Percentage	Probability of seeing at least X consecutive losing trades within a 50-trade period
	2	3	4	5	6	7	8	9	10	11
5%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%
10%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%
15%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	99.9%
20%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	100.0%	99.8%	99.1%	97.2%
25%	100.0%	100.0%	100.0%	100.0%	100.0%	99.8%	98.9%	96.2%	90.7%	82.2%
30%	100.0%	100.0%	100.0%	100.0%	99.6%	97.7%	92.2%	82.3%	69.1%	55.0%
35%	100.0%	100.0%	100.0%	99.7%	97.1%	89.0%	75.2%	58.5%	42.6%	29.6%
40%	100.0%	100.0%	99.9%	97.6%	88.4%	71.3%	51.7%	34.6%	22.0%	13.5%
45%	100.0%	100.0%	98.9%	90.7%	71.7%	49.1%	30.3%	17.6%	9.9%	5.4%
50%	100.0%	99.8%	95.2%	76.8%	50.8%	29.2%	15.5%	7.9%	3.9%	1.9%
55%	100.0%	99.0%	86.0%	57.5%	31.3%	15.2%	7.0%	3.1%	1.4%	0.6%
60%	100.0%	95.8%	70.4%	37.7%	16.9%	7.0%	2.8%	1.1%	0.4%	0.2%
65%	99.8%	87.8%	50.9%	21.5%	7.9%	2.8%	1.0%	0.3%	0.1%	0.0%
70%	99.0%	73.1%	31.8%	10.6%	3.2%	1.0%	0.3%	0.1%	0.0%	0.0%
75%	95.8%	53.0%	16.8%	4.4%	1.1%	0.3%	0.1%	0.0%	0.0%	0.0%
80%	86.5%	32.0%	7.2%	1.5%	0.3%	0.1%	0.0%	0.0%	0.0%	0.0%
85%	67.2%	15.0%	2.4%	0.3%	0.1%	0.0%	0.0%	0.0%	0.0%	0.0%
90%	38.9%	4.7%	0.5%	0.0%	0.0%	0.0%	0.0%	0.0%	0.0%	0.0%
95%	11.5%	0.6%	0.0%	0.0%	0.0%	0.0%	0.0%	0.0%	0.0%	0.0%

The figures in this table are based on a 50-trade period, or roughly what you would receive over a two-year subscription to most of our premium services. 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.

For example, 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 having 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 and reap the rewards of the hot streaks and higher returns of winning trades stand a better chance of ultimate profitability over the longer haul.

For example, one of our services had a track record that illustrates that 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 1999, logging 47 trades over the year. The profit statistics closely followed the overall series numbers: the winning percentage was 32 percent (15 winners), the average win and loss returns were 97 and minus 34 percent, respectively, and the portfolio return was 50 percent for the year. The most interesting number, however, is that this service experienced 10 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. 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 (that's our job), while staying in the game by using proper money management principles (that's your job).

Allocation is critical

In the same spirit of "staying in the game," we now turn our attention to allocations per trade. We will not attempt to tell you a minimum dollar amount to trade. This is a decision best left to each individual investor that takes into account their overall profit goals and costs of trading (e.g., commissions). Rather, our goal in this report is to discuss the percentage allocation to each trade.

In an excellent chapter on money management in New Thinking in Technical Analysis: Trading Models from the Masters (Bloomberg Press), Courtney Smith discusses how to "play the game long enough to master the skills and information needed to become a profitable trader" using a system he calls the fixed fractional bet. Simply stated, every trade should represent a set percentage of your total account.

For example, let's say you have $25,000 available for options trading and you wish to allocate 10 percent of your total account to each trade. You would therefore trade $2,500 for your first trade. Assume the trade gains 80 percent, or a $2,000 profit. Because your account size is now $27,000, your next trade would be for $2,700 (0.1*27,000). Now let's say your first trade lost 40 percent (remember you need to let your winners run and cut your more numerous losses short), or $1,000. Your account would now stand at $24,000, meaning that you would allocate only $2,400 to your next trade. Notice how this differs from a fixed-dollar strategy in which you would invest $2,500 in each trade.

We should note that with options trading, it is difficult, if not impossible to trade exactly 10 percent (or whatever percentage you choose) on each trade. It is rarely the case that an option's premium will divide evenly into your dollar allocation for any trade (e.g., five $5 contracts, or $2,500). The best solution is to trade as close to your allocated percentage without going over. That is, if your allocated amount for a particular trade is $2,500 and you're interested in a $7 option ($700 per contract), you should trade only three contracts ($2,100).

Also, do not let your allocation dictate what option you will play. For example, say you have $2,500 for a trade and your trading system calls for higher-premium in-the-money options. If you have your eye on one priced at 7 (three contracts, or $2,100), don't opt for a cheaper out-of-the-money option priced at 3 (eight contracts, or $2400) just so the total trade is closer to your allocated amount. In other words, don't compromise your trading system for the sake of getting nearer to your allocation.

The power of convexity

One of the primary advantages of the fixed fractional bet system is the principle of convexity - playing more dollars on the way up, while fewer dollars are at risk after each losing trade. On the downside, this system keeps you in the game longer by allowing you to weather the losing streaks that will inevitably occur. For example, if you start with $25,000 and play the same $2,500 per trade, you will lose half your bankroll ($12,500) if you start off with 10 consecutive losses of 50 percent per trade. While it is unlikely that you will have such a streak right off the bat, it is not beyond the realm of possibility. However, the fixed fractional system has quite a different outcome. In fact, this methodology comes out $2,468, or nearly 20 percent, ahead of the fixed investment approach, as shown below:

On the plus side, let's assume you enjoy five straight winning trades of 100 percent apiece. Investing $2,500 per trade will result in a portfolio of $37,500 (25,000 + 12,500). On the other hand, the fixed fractional bet system results in a portfolio value of $40,263, or 7.3-percent better, as shown below:

In the real world, of course, you will encounter interspersed winners and losers, although the losers will most likely be more frequent. As we have stated repeatedly, the goal of options trading is to keep afloat long enough to take advantage of the bigger winning trades and the winning streaks that will also occur. And proper money management is the best way to play longer. As Smith states, "…risk management rules are really ways of dealing with the psychology of trading…[which] is the most important aspect of trading…discipline is the key psychological trait that the trader needs to make money. Risk management rules are an effort at trying to enforce the necessary discipline."

Consistency is the key

One other thing we should mention. Don't vary the percentage you allocate trade by trade. Don't double up on a trade after a loss hoping to win your money back right away. There's a technique some blackjack players use in which they double their bet after each loss, the idea being that eventually the cards will turn in their favor and they will be ahead. That's fine (we suppose) if you're betting $10 chips since you likely will have a sufficient bankroll to stay in the game long enough for that to happen.

But options trading is not so forgiving. The wins are not as frequent, the market may be turbulent and volatile, your system may be flawed, and you might run into a series of trades that will wipe you out. Sure, you may get out of the hole with that one winner, but what if doesn't come in time? If you're sitting on the sidelines with no cash, there's positively no way to benefit from those big winning options trades. And as the saying goes, you miss 100 percent of the shots you never take.

One reason we focus on consistency is that options buying by and large involves more losing than wining trades. In exchange for having more losers than winners, you will also achieve bigger average profits on your winners than on your losers. Success is dictated by using proper money management to stay in the game long enough to reap the rewards of the bigger, though less frequent, winning trades. This brings up an issue that we have not addressed - increasing one's allocation after a series of winners. This is just as dangerous as increasing the percentage after a losing trade. Why is this so?

Remember that there will always be losing trades. Guessing which trade will be profitable and which won't will have dire consequences if you guess incorrectly. Putting a higher percentage in a loser and less on a winner will ultimately lead to decreased profits. Of course, allocating more to the winners and less to the losers would result in huge profits. But given that you will likely encounter more losing than winning trades, the odds of picking correctly are stacked against you.

The table below illustrates how increasing your allocation can be hazardous to your portfolio's health. Trader One decided to press his allocation to a third of his portfolio (33 percent) after two big winners, while Trader Two stayed the course. The next three trades produced two 50-percent losers and one 100-percent winner. Despite having a bigger allocation in the winner, Trader One's performance suffered markedly due to the larger amounts allocated to losing trades. This difference will become even more pronounced as the overall winning percentage drops below 50 percent.

Option trading is a statistical game that generally involves a higher percentage of losing trades. Increasing your allocation to recover quicker from a losing streak or to take greater advantage of a winning streak is not in your best interest statistically. Stay with your plan. Be consistent. Your bottom line will thank you for it.

Review your portfolio regularly

We also realize that you may not have the time to evaluate your portfolio on a day-by-day or trade-by-trade basis. However, we still highly recommend that you look at your portfolio situation on a regular basis (monthly or quarterly) to assess how your money management approach is working. You may find that your portfolio has increased in size and in order to maintain the same percentage allocation to each trade, you must up your dollar commitment for the time being. Or, you may find that it is necessary to scale back on your dollar commitment if the portfolio has experienced a setback, so that you are able to stay in the game and participate in the next big winner or winning streak. Furthermore, after a series of evaluations, you may decide that the current allocation (say 15 percent) to each trade is too aggressive. You might then need to back it down because the portfolio fluctuation (volatility) is too much for you to stomach.

Working together

Options trading is not easy. Before beginning, you have to know and understand how options work, how they are priced, how their prices are affected by many different market factors, and what strategies are available. Then you need a reliable method to judge the direction and speed of movement of the underlying stock or index. Once you have the pieces, you then need to tailor a strategy to fit with your expectations for the stock or index. Once you've taken care of the trading side, you need to overlay a smart, disciplined approach to money management, the primary objective of which is to keep you in the game for a long time.

Our goal in this article is to provide a deeper understanding of some of the mathematical probabilities associated with trading options. Based on the above principles, it is important for options traders to reevaluate the total dollar amount invested in every trade by examining whether they can withstand a string of losing trades that will inevitably occur over a certain number of trades.

For our subscribers, an analysis of your own situation may reveal that your current trade allocations will not hinder your ability to profit with us 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. 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.

For our subscribers, let us do the stock analysis legwork. Let us sweat the details about what strategies and options to play. We will provide you with option trades that are derived from our unique Expectational Analysis® approach, which we believe gives you the optimal in potential reward versus risk. Let us also keep a close eye on your positions. We will provide information on how to manage each position so that your winning trades more than make up for your losing trades. However, without proper money management and a commitment to withstand the bumps in the road, you will risk bottom-line profitability. Ultimately, we are confident that you stand a better chance of succeeding if we do our part by properly managing each trade and you do your part in terms of responsible money management. Working together, we'll give you the best chances for profiting using options.