Money Management is a very important (and often ignored) aspect of trading and selling options. Without it, you’re like a ship without a rudder – it won’t end well.
Without a good option trading money management approach, it is unlikely that an option seller will be around long enough to enjoy some of the profitable opportunities that will eventually come their way.
So, let’s give it the attention it deserves, shall we?
Table of Contents
Side Note: I plan to make this a 3 part series where I explore two other money management approaches. Today's article draws on someone I met that used to trade options starting in the early 80s. This strategy is most useful, I feel, for beginner options traders just starting out. It's main focus is to preserve and protect capital right from the off.
What Is Option Trading Money Management?
Money management covers the allocation of funds. It includes topics like portfolio make-up, diversification, the amount of capital to risk in any one position, risk reward ratios and so on.
Why Is Money Management Important?
Firstly, option trading money management is essential because without it, it is almost impossible to trade in a profitable way over a long period of time.
Imagine an investor, who, believing he is onto a good thing, sells puts in to a single position. No diversification!
This is not a good money management strategy, no matter how good an opportunity it might seem at the time. If it turns south, the options seller will be wiped out.
This is somewhat of a simplified example. But you do not need to be a sophisticated options trader to appreciate the foolhardiness of such an approach.
The point is, a good option trading money management programme would have prevented the investor from committing such a cardinal error. It would have ensured that they were around to fight another day in the stock market.
Half In Half Out: A Money Management Plan For Beginner Options Traders
There are many approaches that an options investor might adopt. What follows is an outline of one of them.
It is not necessarily the best (there is no one definitive plan that can be labelled the “best” for every type of investor.
Yet, it is one that encapsulates the essential trading principles: caution, logic, discipline, and most important—common sense.
I call it the Half In Half Out approach and the best way to explain it is with the use of an example.
Imagine an options trader with a fund totalling $120,000. The first thing he should do is divide it into two.
The one half, the $60,000, is kept in cash and put to one side. By cash, we mean that it is not used to sell to open any new cash secured put positions. Instead, it can be invested in risk-free immediately realised instruments that pay us interest.
PRO TIP At the time of writing this, Interactive Brokers pays up to 5% on any cash over $100,000 that is not used. This includes cash secured for selling put options. So you can earn interest whilst you are selling cash secured puts on your positions. Pretty darn good!
The remaining $60,000 then, is subdivided into portions of $20,000 each. These are then used to open three new positions. Please note that three positions is the maximum number of positions that should be opened.
Another important point to appreciate is that, just because you have allocated funds to three positions, it does not necessarily mean that you must open all three as quickly as possible.
Overtrading, or forcing a trade, is not advisable. It is much better to be patient and wait for the right opportunity to come along.
Let’s assume the fund is now fully invested (three open positions). Two trades might be profitable, each making say $400, and the third position we booked a small loss of $50.
The total working fund should now stand at $60,750 ($60,000 + $800 profit, minus $50).
The total working capital can now be reapportioned. The cash reserve now totals $60,750 leaving three trading positions each allowing $20,250 per trade.
|Open Positions (3 trades)
|Initial Amount ($)
|Total Working Fund After Trades
|Total Working Fund
|Per Trade Allocation
To summarise: This is the way the fund might go if you book some profitable trades. However, options trading is not just about making money but it’s also about not booking a loss.
One of my rules to option trading is never take a loss. To ensure this you have to think about selling options in a campaign like structure where you record every leg of each trade you sell to open a position.
If you are not sure how to log your option trades, you can grab a free copy of Options Campaign Manager which is what I built and use myself on every single option trade I make.
Building Good Trading Discipline
This Half In Half Out approach builds good trading disciplines when beginning your options trading journey.
By imposing a limit on the number of positions that you may open you are more compelled to closely monitor these positions. it also allows you to get to know the companies you are trading in on a more intimate detail.
And let’s not forget our dear friend, diversification. Because, you know, putting all your eggs in one stock-shaped basket is a bit like skydiving without a parachute.
As options traders we should also look to diversify these three trades across different industries and sectors in case of any cat 5 stock market hurricane that may arise.
Getting Things Wrong
Above all as options traders, try not to become emotional.
Fear and greed are the two arch enemies. Just because you have got one trade wrong doesn’t mean you are a bad options trader.
Understand your mistakes, learn from them, and move forwards.
If you are struggling getting started, I did a great Q&A with a self taught options trader that now makes $30,000 per month selling cash secured puts and covered calls. His mantra is “Begin, the rest is easy.”