Capital Allocation

Every three to six months, I will revisit some of the important themes and strategies used by Cabot Options Trader since I became the editor. 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, please go to www.cabot.net and the Options Trader page. On the right hand side of the page, I recommend you read some of the past articles I’ve posted, such as Guide to Options Trading, Options Terminology and the other options education topics on the site.

 

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