Risk and capital management.  I don’t care what “system” you use to trade options, if you do not employ risk and capital management properly, you are setting yourself for failure.  All the best methodologies mean exactly zero if you are not disciplined and do not understand the risks you are taking on.  The first thing that many new traders (and even some seasoned ones) do not understand is that options trading is not like day-trading futures

Most people define their lot size when day-trading futures is based on what their clearing house will let them trade on margin which is simply a function of account size.  If I have a $10,000 account, maybe my clearing house will let me trade 5 lot of ES.  (This is just an example, not necessarily indicative of an actual margin situation).  This is not the case with options.  The way I look at it, no one is a “2 lot trader” or a “10 lot trader”.  If all options trades cost the same, then I am right with you.  That is not the case though.  So, your risk is based on “capital at risk”.  Typically, this is expressed as some percentage of one’s account value.  Let’s say an options spread is trading $0.50.  Let’s also assume that we want to allocate 5% of our account value to any given trade.  If you have a $25,000 account you would execute a 15 lot ((25,000 * .03)/(0.50/100)).  If your account size is $50,000 you would execute a 30 lot (twice as much).  What’s important is that each person above has the same percentage risk, not the same dollar risk.  Ok, that makes sense you say to yourself.  What are the ramifications of NOT approaching things this way?  Let’s look at things in the most extreme instances (that’s when risk management matter most right?). 

Let’s talk about what happens when you have ten losing trades in a row.  If you use the “fixed investment” approach, you will lose 50% and have an account balance of $5,000.  If you employed the “fixed allocation” approach, you would lose 40.13 percent of your account and your balance would be $5,987.37.  Nearly one thousand dollars less in losses!  It is even more powerful when you are the winner and can use the power of compounding.  If you have ten winners in a row and employ the “fixed investment” approach you will be up 50% and have an account balance of $15,000.  Using the “fixed allocation” approach, you would have a gain of 62.89% and have an account balance of $16,288.95!  If you care to take a look through the math, please refer to this chart:

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