An important consideration in any trading strategy is how many contracts to trade or how much money to allocate to a particular trade. This article answers this very question.
There are two parts to this question:
- How much capital should you commit?
- How many contracts should you trade?
1. Capital to commit
Futures and options trading is far from a risk-free pursuit. Careful consideration, therefore, must be given to how much of your total purse to put towards derivatives trading.
Risk adverse logic tells you the less, the better for the beginner. It all comes down to your aversion to risk. Those who find it hard to sleep while positions are open should not risk very much (in fact, they should probably not be trading in the first place). Those who can place a position and have the confidence that it is under control can afford to risk a little more. Many think 10 to 20 per cent of your total investment pool is an ideal place to start.
The correct answer differs from one person to the next.
2. Contracts to trade
There is also the issue of how much of your trading stake to risk on any one trade. If you read Market Wizards: Interviews with Top Traders by Jack Schwager, you will see the majority of successful traders interviewed suggest no more than 5 per cent of your money should be risked on any one trade. This 5 per cent refers to your stop-loss level, not the theoretical risk of the trade (since some strategies have theoretically unlimited risk).
Whatever you decide to place on any one trade, keep this in mind: use small amounts when you first start, since this is when you will make the most mistakes.
The most common approach to money management is the Percent at Risk method and this is best explained by example. Let’s say you have an account size of $50,000 and want to risk no more than 10% ($5,000) on any one trade.
You’ll need to make an estimate of your maximum risk on anyone trade. Let’s say it is $2,500. This means you can trade just two contracts ($5,000 / $2,500). If your stop levels are tighter and prefer to risk only $1000, you can trade 5 contracts ($5,000 / $1,000).
It is a relatively simple method but is actually quite common.
To be fair the subject of money management is a large one. Entire books have been written on the subject. It is a fascinating area, particularly for those that like reading about numbers. Two great books on the subject are: