Saturday, June 25, 2005

Addendum - Overtrading

There has been discussion that Gold Options Made Easy misses a key point with regard to overtrading. Overtrading means trading too many positions for the amount of capital you have in your account.


Guy Bower put this together to clarify some rules.


A key question in options trading is that of how many contracts to trade on any one trade.

This is a pivotal question. The concept of money management can have the most dramatic effect, both positive and negative, on your trading performance and capital.

Trading systems will recommend an allocation based on measured or perceived risk of any one position. An example of such a recommendation is: “In this trade allocate $5000 per contract”.

It means for every $5000 in your account, you trade one contract in the specific recommendation. It is unwise to ever trade more contracts than suggested, but you can certainly trade fewer.

Multiple positions

At any one time your trading system may have two or three recommended strategies. It is intended that you trade these simultaneously. Suppose the recommendation is three new trades with the following allocation rules:

  • Trade A: One contract per $5,000
  • Trade B: One contract per $10,000
  • Trade C: One contract per $10,000

And suppose you have an account balance of $50,000. With these examples you would trade 10 contracts in Trade A and 5 contracts in each of Trade B and C. Note you can trade these positions simultaneously.

Margins

It is important to note that the $5000 or $10,000 number is not the margin for the position. Margin is the deposit taken by the exchange or the broker from your account as a deposit for holding a position. For options, this figure will change daily based on factors such as the underlying market price, the option price, time to expiry and volatility. The margin for a single contract might range from a couple of hundred dollars to a few thousand depending on these circumstances.

The statement from your broker will show you margin amount for any one position or all positions. If it’s not clear on your statement, just ask your broker for an explanation.

Margin to Equity Ratio

A key measure for you to calculate is the margin to equity ratio. This is simply your total margin divided by your total balance.

Margin to Equity Ratio =

Total Margin

%

Account Balance


Most New Trades in option trading systems should have a Margin to Equity Ratio of around 20% when first placed. Some might have more, some less.

Rule of Thumb: It is not recommended you take on a New Trade when your Margin to Equity Ratio is greater than 50% or 60% for your total account (all positions). This means you are trading too much.

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