An Options Money-Management Strategy

Depending on trading styles and risk tolerance, traders can select among a number of money management approaches for options trading; these will dictate how much to invest (and reinvest) in a given trade. Below, we outline three such strategies and show their benefits as well as potential drawbacks.

Strategy 1: Reinvest both the principal and accrued profits

One of the most popular money management strategies involves the reinvestment of both the principal and profits after each (positive) trade. For instance, if a trader allocates $2,000 to a first trade and then makes a 50% profit, he/she would be able to invest $3,000 in the following trade (the principal of $2,000 plus the $1,000 profit). By investing in this fashion, a trader will benefit from the power of compounding; however, trading options this way is aggressive and very risky - a trader could quickly wipe out an entire portfolio. It is not recommend approach for options trading!

Strategy 2: Invest a fixed percentage of the portfolio

Another popular money management strategy is to allocate a fixed percentage of the portfolio to each trade. For instance, a trader may decide to invest 20% of a portfolio in each trade. Assuming a $10,000 portfolio, the trader would thus invest $2,000 per trade. Should a trade result in a 50% profit, the trader would then have $11,000. He or she could then allocate $2,200 (20% of $11,000) for the next trade. This approach to options trading is considered conservative.

Strategy 3: Invest a fixed amount

A third way to allocate funds is to invest a fixed amount per trade. For instance, a trader with a $10,000 portfolio could set aside $2,000 for each options trade. Even if a trade resulted in a 50% profit, the trader would still only invest $2,000 in the next trade. This strategy is less profitable than strategy 2 discussed above; however, it allows a trader to recover more quickly from (a) losing trade(s). In order to increase their profit potential in good times, traders sometimes combine this approach with a higher investment once a certain portfolio size has been reached. For instance, a trader may decide to invest $3,000 per trade once his or her portfolio has grown to $15,000.

The comparison table below shows how a portfolio would fare using the three money management strategies discussed above. The following assumptions are made:

• The initial portfolio value is $10,000;
• Three options trades are made: The first leads to a loss of 70%; the second and third each produce a gain of 50%.
  

I myself use Strategy #3 and use each months gains as general living expenses.