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Tuesday, February 9, 2016

Smallness: the case against trading excessively small

 
Trading small is good. So says the Bible. You keep the size of your bets small so that the destiny of your account doesn't depend on the outcome of a single bet. By trading small, you deploy several positions and give yourself a better chance, letting probabilities play out in the long run while reducing your risk of ruin.

That's all heavenly. We're living truly wonderful times.

However, the other day I read something alone the lines of "you can never trade small enough". Suggesting that the more microscopically you trade, the better. And that's where [cough, cough], the sensible person needs to recognize all extremes are bad. Both in bed, and everywhere else, including trading. So, let us go against the Gospel.

Let's say you are a small trader with a $10,000 account and you want to deploy an Iron Condor. The Gospel dictates you don't risk more than one percent of your account on a defined risk trade. So, the maximum size of your bet is $100.

You want to play an Iron Condor with a Max risk of $100. Assuming that you are looking to put your position with an overall 68% probability of success, that leaves you generally collecting about half that risk in credit, which is around $50 or a bit less.

Now, you are also going to be smart of course, and you will manage your winner at 50% of max profit. That is, you will take your position off the table once it reaches a glorious +$25 balance.

Here's the problem with this. Assuming the least commission intense scenario, where you only needed to deploy one contract per leg in order to put the $100 risk, you are trading 4 contracts in total. You will get in, and then you will get out. Using a simple commissions schema of $9.99 per order fill plus $0.75 per contract, that is a total of $12.99 per round trip. Do it twice, and you have been feeding the broker with $25.98 at the end of the story.

Morale: You had a plan, you took the risk, you executed correctly, you were disciplined and had a winner. Yet, after all you are poorer.

You can only trade so small before all you are doing is putting risk on the table for just crumbs; assuming risk, only to feed your broker and leave yourself little chance to make any decent money.

So, yes. Trade small. It is a wise advise. But don't trade too small, as the size of your winners will be so tiny* that you will just be wasting your time, putting risk on the table without any chance of worthy compensation.

LT

* I'm obviously focusing on the options selling business in particular. Other strategies are able to deploy small amounts of capital and obtain returns that are several times the risk, such as Trend Following systems, Long Out of the Money Options, etc.

Related Articles:
No you don't (why being a contrarian and selling OTM options make sense)
Cons of Index Funds: The case against Passive Index Investing


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