The real problem with losing money
An options trader, Mr. RRR, enters the markets with ₹1,00,000. He scans the market in search of a 'good trade'and analyses the stocks. After seeing the right opportunity, he buys call options of a stock and deploys entire capital. But, he wasn't prepared for what was about to happen. Against his expectations, the markets fell, the premiums dipped 50%, and the profit and loss figures made him exit the trade. Devastated, he is now left with the trading capital of ₹50,000
To recover the lost capital, he must now make 100% profit in order to reach his initial capital of ₹1,00,000. This may not be easy considering how volatile and versatile options can be and not to forget the fear factor. You need to work doubly hard to recover what you have lost.
If only Mr. RRR had followed the sound principles of money management, he could have spared himself a world of trouble.
Benefits of Money Management
So, what is money management? It is the process and discipline of managing your trading capital to maximise your profit potential and diversify your risk. The benefits of money management are enormous. Among them, the biggest are:
i) Objective-based investing
ii) Control over your money
iii) Defined investment strategy
iv) Efficient risk management
v) Increased probability of higher returns
If you list all the benefits, money management is practically everything. The best way to achieve all the above benefits is through appropriate position sizing. It is the most crucial step in how you handle your money. Position sizing decides how much money you will gain and how much you can lose on each trade.
How can I apply position sizing correctly?
Using correct position sizing involves weighing three different steps to determine the best course of action.
Step 1: Define your strategy
Most traders take positions of random qunatity. Instead, define your strategy before you enter into a trade. For instance, traders with small portfolios can pre-define their risk in any trade to say 2% to 4%. Meaning, if the trade did not go in your favour, you would not lose more than 2% to 4% of your total capital.
Step 2: Know your potential profit and loss
To achieve Step 1, a trader must always know the potential profit or loss before the trade is even deployed. Luckily for us, options trading, especially options strategies, allow us to calculate both these numbers beforehand. Thus, traders are exactly aware of how much they can earn or lose in any options trade instead of fishing in the dark.
Step 3: Limit your losses
Lastly, If markets are unfavourable, traders must limit their losses to save their capital and live to fight another day. One way to do this is by strictly implementing stop losses. But this may not work if you take positions overnight. However, the easiest way to tackle the overnight exposure is by using hedged positions or options strategies.
Which of these steps have you been skipping in your trades? Start implementing all of these steps and UPgrade your trading level from beginner to professional.