How much of your net worth should you allocate to each
This frequently asked question lacks a definitive answer. Why?
Because we all have a different set of life goals and live under
different circumstances. There are just too many variables out
there (age, income, retirement goals, spending habits, etc.) for
there to be one simple answer.
But we can all agree that we should have exposure to several
investment classes. This much is certain - it's just up to you to
figure out how to split up your own pie.
Without a doubt, options investing should get a healthy slice of
And brokers can help. Options brokers allow you, the investor, the
flexibility to allocate your account by specified dollar amount,
specified quantity, percentage of available buying power, etc. It
is then your responsibility to figure out what works with your risk
tolerance and investment goals.
This brings us to the important and rarely covered topic of
Too many investors, especially options investors, have a casual
attitude toward the management of their investment portfolios. In
the constant race for profits, risk management and money management
seem to be secondary. The almighty return, the "we want a lot of
return, we do not want any risk, and we need the money by Monday"
mentality, seems to override the importance of position sizing.
This is particularly true in the options arena. How many websites
have you come across that tout outlandish gains with minimal risk
and great consistency? All that I need to say in reference to these
is... "think about it!"
My cynicism does not mean that the typical options investor can't
beat the market by a decent percentage annually.
It just means that "shooting for the moon" is not sustainable.
The Gallup organization and UBS recently conducted a survey that
found 39% of respondents believed stocks would deliver at least a
15% annual return over the next ten years.
This projection just goes to show how wishful thinking consumes a
large portion of the investing publics' attitude toward returns.
Historically, the notion of such returns is unreasonable.
"Whenever I enter a position, I have a predetermined stop. That
is the only way I can sleep. I know where I'm getting out before I
get in. The position size on a trade is determined by the stop, and
the stop is determined on a technical basis." --
Position sizing is possibly the most important aspect of any
options portfolio and trading system. As an investor you must
always be aware of risk management (how much you are comfortable
losing per trade) and money management (the size of the position
So, as far as "how much should you allocate to each strategy",
trade, etc., the answers are ambiguous. I can only speak to the
strategies I use, and the sources that I use to inspire my tested
One of the latter is Dr. Van.K. Tharp. In his highly recommended
Trade Your Way to Financial Freedom
, he discusses in great detail the importance of position sizing.
In his book, Dr. Tharp back-tests and compares the effects of
different position sizing methods on investment accounts. His tests
were based on a trading account of $1,000,000 using a trading
system that 595 trades over 5 ½ years.
Here are some of more notable position-sizing methods he compared
and the results:
- 100 Shares of stock per trade
- Performance - 0.58% annually
Percent- Risk Model
- 100 shares per $100,000 of equity per signal
- Performance - 5.75% annually
- 1% of the account equity per signal
- Performance - 20.92% annually
His tests produce some interesting results to say the least and
highlight the importance of position sizing. As I have mentioned
before, each investor has different risk tolerances and goals. Dr.
Tharp's results are by no means the "holy-grail" for
Each method has pros and cons under varying market conditions.
Ultimately as the investor, you need to create suitable investment
objectives that coincide with your risk tolerance.
With that said, go ahead and explore varying ways to use position
sizing. Try out different scenarios based on the trades we have
placed so far this year. Discover which one fits your investment
objectives and stick with it.
Remember, investing is not a sprint. It is a marathon.