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Options Investment Strategy
Description: Options Investment, Investment Strategy,
Options, Investment, Options Strategy, Money Allocation, Trading Strategy, Options Trading
It is a good idea to develop a money trading (money allocation) strategy
before jumping into options trading. Even a good trading system can become fatal
when used in the wrong way. Below you will find a few reasons why we recommend
that you do a few calculations before beginning to implement any trading system.
When a trader buys an option contract, he or she controls 100 shares of the
underlying securities. Because of this leverage, option trading is one of the
most attractive investment methods to speculators. However, because of this
leverage, option trading is considered to be one of the riskiest types of
investments.
Because of the risk associated with options, it would be wrong to state that
option trading is similar to stock trading and that stock trading strategies can
be applied to options trading. When purchasing stocks, a trader may invest his
entire portfolio in a single public company. It would be a good idea to
diversify the investment. However, even when investing in a single company, the
risk of losing the entire value of the portfolio is small because the odds that
the company will file bankruptcy within a month and the price of the bought
stock will drop to zero are relatively small. On the other hand, investing the
whole portfolio in options could "kill" the portfolio - if the options
purchased are worthless when they expire, all invested money will be lost.
Because of the higher trading risk, it is wrong to apply stock investment
strategies (money allocation strategies) to options and it is a very poor idea
to invest all of one's money in options.
There are two very popular option investment strategies (money allocation
strategies) used by traders. One of these strategies involves investing a
predetermined, fixed dollar amount in each trade. Another strategy invests a
predetermined, constant percentage of the portfolio in each trade. These two
investment strategies can be used in stock trading as well. By doing some math,
we are able to see the advantage that use of these money allocation trading
strategies has over investing an entire portfolio in options trading.
Let's assume that a trader uses a trading system
that on average has two +30% profitable trades and one 50% loss. In summary, it
is a trading system that yields a profit of +10% (2 * 30% = +60% profit minus a
50% loss). This doesn't sound bad. So, let's calculate 12 trades for each
trading strategy.
Investment Strategy #1: Investing the entire portfolio in each trade
| Table #1: Entire portfolio invested
in each trade. The initial portfolio size is $10,000 |
||||
| Trade | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $10,000 | -50% | $5,000 | -50% |
| 2 | $5,000 | +30% | $6,500 | -35% |
| 3 | $6.500 | +30% | $8,450 | -25% |
| 4 | $8,450 | -50% | $4,225 | -58% |
| 5 | $4,225 | +30% | $5,423 | -56% |
| 6 | $5,423 | +30% | $7,140 | -29% |
| 7 | $7,140 | -50% | $3,570 | -64% |
| 8 | $3,570 | +30% | $4,641 | -53% |
| 9 | $4,641 | +30% | $6,033 | -40% |
| 10 | $6,033 | -50% | $3,017 | -70% |
| 11 | $3,017 | +30% | $3,922 | -61% |
| 12 | $3,922 | +30% | $5,098 | -49% |
As you can see, the first lost trade has made unfixable damage to the portfolio and the +10% profitable trading system has resulted in a loss of half of the portfolio after 12 trades with this trading strategy. With this strategy, the bigger the losing trade, the greater is the damage done to the portfolio, and a 100% losing trade (very real in options trading) takes the entire portfolio down to the bottom zero line. This trading strategy is not recommended for options trading.
Investment Strategy #2: Investing a fixed amount in each trade.
| Table #2: $1,000 are invested
into each trade. The initial portfolio size is $10,000 |
||||
| Trade | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $1,000 | -50% | $9,500 | -5% |
| 2 | $1,000 | +30% | $9,800 | -2% |
| 3 | $1,000 | +30% | $10,100 | +1% |
| 4 | $1,000 | -50% | $9,600 | -4% |
| 5 | $1,000 | +30% | $9,900 | -1% |
| 6 | $1,000 | +30% | $10,200 | +2% |
| 7 | $1,000 | -50% | $9,700 | -3% |
| 8 | $1,000 | +30% | $10,000 | 0% |
| 9 | $1,000 | +30% | $10,300 | +3% |
| 10 | $1,000 | -50% | $9,800 | -2% |
| 11 | $1,000 | +30% | $10,100 | +1% |
| 12 | $1,000 | +30% | $10,400 | +4% |
From the table above, we see that the strategy of investing a predetermined fixed amount in each trade protects the system from big losses. With use of this strategy even a trader is able to recover from the losses (even from a trade that results in a loss of 100%) if the trading system used delivers an overall positive average return.
Investment Strategy #3: Investing a percentage of a portfolio in each trade
| Table #2: 10% of the portfolio is
invested into each trade. The initial portfolio size is $10,000 |
||||
| Trade | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $1,000 | -50% | $9,500 | -5% |
| 2 | $950 | +30% | $9,785 | -2% |
| 3 | $978 | +30% | $10,079 | +1% |
| 4 | $1,008 | -50% | $9,575 | -4% |
| 5 | $958 | +30% | $9,862 | -1% |
| 6 | $986 | +30% | $10,158 | +2% |
| 7 | $1,016 | -50% | $9,650 | -3% |
| 8 | $965 | +30% | $9,939 | -1% |
| 9 | $994 | +30% | $10,237 | +2% |
| 10 | $1,024 | -50% | $9,726 | -3% |
| 11 | $973 | +30% | $10,017 | +2% |
| 12 | $1,002 | +30% | $10,318 | +3% |
This strategy is very similar to investment strategy #2. It protects the portfolio from big losses, but has some compound effect and, with only small losses, can deliver greater profit over a longer period of time than the second strategy. At the same time, with big size losses, this strategy is less profitable than strategy #2.
Recommendations for selecting an investment strategy for options trading
- Investment strategy #1 is not recommended for options trading. Sooner or later, one big loss may result in a loss of the entire portfolio or unfixable damage to the entire portfolio. Investing the entire portfolio in options trading is simply gambling.
- Investment strategy #2 is recommended for options trading. This strategy protects the portfolio from big losses. It does not have a compound effect, but allows one to recover more quickly from a losing trade than strategy #3.
- Investment strategy #3 is recommended for options trading. This strategy also protects the portfolio from big losses and has some compound effect that allows the portfolio to growth more quickly.
- Wes recommend that you know the average size of losing trades, average size of profitable trades and the average number of winning and losing trades in the options trading system you use before selecting a money allocation strategy.
- The simple calculation presented in the tables above may help you to choose which investment strategy is more profitable for each trading system.
- The same calculation may help you to decide the amount that can be invested in each options trade. 10% of the portfolio is considered to be a conservative investment in an options trade.
- A riskier trader might be willing to invest more than 10% of the portfolio in an option.
- We don't recommend that you invest more than 30% of your portfolio in an options trade.
- For investment in uncovered options, another more complex calculation will take into account the margin requirements for this type of option trading.
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