Maximize Your Profits Without Increasing Your Risk
Editor's note: Proper position sizing is critical to your long-term investing success.
But how do you know what the right position size is for you on any given trade?
In today's Masters Series, Dr. David "Doc" Eifrig shares his approach, which dates back to the 1950s...
Maximize Your Profits Without Increasing Your Risk
In the 1950s, John Kelly was a chain-smoking scientist working at Bell Labs. This was the world's most prestigious scientific-research center, funded by the Bell Telephone company. It created incredible innovations, including the computer transistor, the silicon solar cell, the first laser, and more.
While watching the hit game show, The $64,000 Question, Kelly got obsessed with an idea: If you have an edge in a betting game, how do you bet to maximize your profits?
Eventually, Kelly published a paper titled "A New Interpretation of Information Rate" that explained his analysis in the context of horseracing.
You may have heard of the MIT Blackjack Team. This was a group of students and former students that worked together for 15 years and earned millions from casinos with complicated blackjack strategies. The "Kelly Criterion," as the main formula has come to be known, was central to the team's approach. It also underlies a lot of Wall Street money-management strategies.
You can input your probability of winning and how much you'll get paid, and the Kelly Criterion will show you how much of your bankroll to bet for maximum returns. However, it's aggressive. That may work for blackjack, but most traders use a simple variant called the "Half Kelly." Just take what the Kelly Criterion says and cut it in half.
Take an honest assessment of the trades you're going to make. We're lucky as advanced option traders to know our potential payout up front and a conservative measure of our probabilities from our option delta.
Take those and find where you fall on this Half Kelly Table...
The negative numbers are bets you should not make. Clearly if you're going to earn 20% on a win and only win 10% of the time, like the first box, you're just going to lose money.
Consider a trade with a 50% chance of paying off that would return 85%. The Half Kelly table tells us to put around 11% into that trade.
Based on 1,000 simulations, if we could make that exact trade 50 times the average portfolio would end up turning $10,000 into $93,000... a fantastic result. And it only has a 12% chance of going bust (defined by losing half of your money).
There's two final things to consider...
First, these numbers only hold up if you have an honest assessment of your likelihood of success. You don't just pick an 80% win rate because you feel like you'll be a good trader. That's how you end up burning through your options account. Be honest and humble. Use the statistics we've taught you how to find and use them conservatively.
Second, this simplified method doesn't account for the fact that you may have multiple open positions and they may move together. If you put 10% into 10 positions all at once and the whole stock market comes down, you can lose everything on one round of trades.
That's why we advocate for cutting your Half Kelly in half again if you have multiple positions and not putting all your money into the market at once.
In other words, with the kind of spreads we look at, a good rule-of-thumb is to put 5% to 10% of your option-trading capital into each trade. That's where we started, but now you can see how we got there and how it's designed to keep you trading, so you can earn the true profits that advanced options can bring.
Here are five key takeaways to remember from this weekend's essays...
- For your first trades, only use a single contract until you are comfortable with trading.
- To be a successful trader, you need to have correct position sizing.
- The simple answer is that you should only invest 5% to 10% of your option-trading capital into each trade.
- You shouldn't be using your full retirement savings to trade advanced options either. The term "play money" sounds dismissive, but that's what you should be using for this strategy.
- If you have multiple open positions, they may move together. If you put 10% into 10 positions all at once and the whole stock market comes down, you can lose everything on one round of trades. Be smart with your position sizing.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Editor's note: Doc's newest trading strategy could be his most powerful one yet... It's designed to turn Stansberry Research's top investment ideas into huge, triple-digit winners – even if the stocks trade sideways. If this sounds interesting to you, be sure to tune in to our event on Wednesday, December 5 at 8 p.m. Eastern time. In the meantime, learn more about Doc's strategy right here.