Every three to six months, I revisit some of the important themes and strategies used by Cabot Options Trader since I became the chief analyst. If you’re relatively new to the service, this will be somewhat of an introduction.
Today, I am going to revisit my recommendation for capital allocation using Cabot Options Trader.
There is nothing that I am more sure of than the fact that I will get some trades wrong. No one, and I mean no one, gets every trade right. If someone tells you that they do, then run in the other direction.
My expectation for myself in trading is that I want to get six or seven out of 10 right. If I get on a hot streak, I might get eight out of 10 right.
Assuming I get six or seven out of 10 right, and I cut my losers fast, and let my winners run, then we should end up way ahead.
Now to do this properly, we need to have a virtually balanced allocation of capital in each trade. That way, we aren’t overexposed to the losers and underexposed to the winners.
As an example, let’s assume you have $10,000 in a brokerage account allocated to options trades. I recommend allocating 5% to 10% of this capital to each trade.
When you receive a trade alert, read my thesis, and decide if you want to put on the trade. If you like the thesis and risk/reward, decide for yourself how much of your 5% to 10% you want to risk on the trade. And remember …. Never go all in!
Let’s look at our current trades:
Buy XLF August 19 Put at $0.47
BUY SU August 31 Call at $0.55
Assuming you have $10,000 in your account, you will allocate 7% of capital to each trade—about $700 to each trade. Since the most you can lose is the premium paid, that would mean you should buy 15 XLF Puts ($700/$47) and 13 SU calls ($700/$55).
This leaves you with $8,580 remaining in your account for your other trades. When we get busy, and I expect that to happen this earnings season, we will likely have between one and eight positions open at a time.
Now let’s say I recommend selling a put spread. For this exercise, I recommend selling a spread where each spread has $3.00 at risk. This time you like the theory, so you allocate 9% for 3 spreads, which risks a total of $900.
You can see where I’m going with this exercise.
This way, if I get a trade wrong, you will not get hurt too badly. And if we hit a couple “home runs,” you’ll end up way ahead.
On a side note, if you are new to Cabot Options Trader or just want to refresh your memory on some of these types of topics, I recommend you read some of the materials I’ve posted, such as Guide to Options Trading, Options Terminology and the other options education topics on the website.