The size of your trades relative to the amount of capital in your trading account is critical to the success of a trader or investor. The difference between a successful trader or investor, and a losing trader or investor can be summed up to the size of the trade relative to the value of your account. If you trade too large for your account, it is just a matter of time that you will suffer a significant loss that cripples your account.
As an experiment, I asked a friend to pick one of his favorite stocks. He picked Zoom. He wanted to buy Zoom at the time it was available for public trading. I asked him for the various parameters like stop loss and target price. He did not have one. Therefore, I purchased 1000 shares of Zoom at $89 per share as a long term investment. As the experiment continues, I also bought a 14 DTE BKS on zoom with a max risk of $2000 and min risk $500, and a max profit of $800 and a min profit of $200. Furthermore, I repeated the same setup every other week for a year. The experiment ran for one year, and the stock position loss a total value of $25,000, and BKS was up $15,000. At the conclusion of the experiment, he realizes his investment size was too large. Being down, 25K plays with your mental psyche, and with real money on the line, he said would have exited the position when it was down 10K. If the loss were only $2000 then he would have been in the position until Zoom takes off to the upside.
Every day when the market opens, it presents new trading opportunities. It is easy to see the potential profit before the risk, and this condition is known as the fear of missing out on a trade. Trading is all about math and letting the probabilities play out in your favor. If you trade too big and suffer a major loss in your account, the probabilities will never play out.
Here are some rules to follow so you can live to trade another day:
- 5% Rule – Don’t allocate more than 5% of your trading capital to any one position. I typically use less than 5% of capital per trade.
- 30% Rule – Don’t allocate more than 30% of your total account value to ALL trades.
Remember, options use leverage. You can earn a significant return with less capital at risk. I typically use much less than 30% of my capital so that when IV spikes to high levels, I have the money available to take advantage of the opportunity.
Also, from experience, a typical stop loss for $89.00 stock is not 20%, but the volatility of the stock. At the time of the research, Zoom’s volatility stop loss was at 62 dollars. That is a 27 dollar drawdown in your account before an upward move.