A common question I get, and mistake traders make, is centered around the leverage that the market gives you. I find that yesterday's slaughtering of BABA is a prime example of the pain investors and traders alike can face when they misuse the leverage that they have. I will try to explain a simple concept that I like to stick to when I make a trade that will hopefully help you understand capital allocation at it's simplest form.
Prior to making a single trade ever, a trader must know their own personal limitations. You should know your maximum tolerance for pain before ever entering a trade. The simplest way to know this tolerance is to simply close your eyes and imagine how you would feel if you lost $X. This comfort level/max pain is different for everyone and is typically associated with the amount of money an individual has to trade with and the number of years they've been trading. There are secondary factors that account for this psyche such as "hot streaks" which is just the individuals confidence in their self, and liquidity (how much cash you will need in the coming days/weeks) among others.
So a simple exercise is to just sit at your desk and think about it. How much money lost makes you uncomfortable? Don't be a smart-ass and say "I'm not comfortable losing any money!" If that's you, then just quit now because you need to have a base line that you're comfortable with in order to even start. Just think about it, start with any number that's relative to your own account size. Start small and work your way up. Once you find that number that makes you a little queasy, that's your max risk. Your risk assessment for all intents and purposes should be derived from that number.
Let's say that hypothetically the number that makes you uncomfortable is $200. From there, try to find a loss amount that you would be comfortable with. Of course no one likes to lose, but we need one that is "not the end of the world" and that will allow you to think rationally and focus on the next setup and not "I need to get my money back!" Let's assume that $100 is your loss amount that you have decided on.
So, for the purposes of this example, $200 is the amount that makes you queasy (max loss) and $100 is the amount that you're comfortable with.
Since $100 is the amount that you're comfortable with to prove you wrong, every trade you take should be centered around that $100. Your risk allocation should be derived with that number in mind. Let's take a look at how this works in practice using yesterday's BABA breakdown.
Since $200 is the most we're willing to lose before we feel like we want to puke and $100 is the most we are willing to lose and feel comfortable, we can assume that we are allowed to make the following:
ONE TRADE WITH A $200 STOP LOSS
TWO TRADES WITH A $100 STOP LOSS
THREE TRADES WITH A $65 STOP LOSS
FOUR TRADES WITH A $50 STOP LOSS
FIVE TRADES WITH A $40 STOP LOSS
SIX TRADES WITH A $33 STOP LOSS
The most important thing you must understand if you are using options is not all options are the same. Some options will cost you more in dollar terms, but be safer because they're closer to the money and have a longer time decay. The farther you are away from the option target the more violent the move will have to be for you to profit. This doesn't mean that you can't profit, but that is less likely for you to do so.
With that aside, and with the risk assessment from the previous section, we are able to dictate just how comfortable we are with a particular setup and trade to assess how much we're willing to bet and risk on the trade. If we use BABA from yesterday as an example here's how it will play out.
After the SEC news yesterday, shares of BABA gapped down and gave a False Breakout Reversal from the day prior. With that being the case, the presumed "path of least resistance" was lower and a move lower was in order.
Let's take a look at the 5 minute chart of BABA yesterday to give a better and more concrete example of this methodology in practice.
As the chart shows, the first 5 minute candle closed at 78.89. Let's round up for the purpose of this example. So hypothetically, BABA had a 5 minute top of 79.9. This gives us a very defined trade for when we want to take it.
I will use the 75 Puts as an example but you can adjust the example to match any of the puts that you were interested in from yesterday. At the start, the 75 weekly puts ranged between 0.24 on the highs and 0.10 on the lows. You can use that range to your advantage when you're trying to adjust whether or not you're overpaying, or underpaying, relative to what was paid previously. So in the case of the 75 weekly puts that ranged between 0.24 and 0.10 we are able to determine that a break in 0.10 is a stop out if the price of the stock goes against us.
In simple terms, as BABA starts to float higher and stall, we want to take a shot at a short against the highs of the session with 79 as our stop and with 0.09 as our options stop. (it is important that you wait for it to stall first as if you don't you're basically just peeing into the wind and could run yourself over by being blind to the stock reversing higher.)
Hypothetically speaking, let's say that we enter the trade with the options priced at 0.15 (in my case I entered with them priced at 0.21). We know that our stop out on the options price will be 0.09 so we know that we are willing to lose 0.06 per contract. Using the 0.15 options entry price and the 0.09 stop out price we can figure out how big a position we are willing to take and reverse engineer our risk tolerance accordingly.
To figure the position size, simply take the % basis that 0.06/0.15 equates to and allocate the appropriate funds to that % stop. In this case, 0.06 is 40% of 0.15.
The question you ask yourself is: "How much can I risk with a 40% stop out and still fall under/at $100 loss on the day?"
With the above controls (0.06 stop out risk and 0.15 cost) we are able to determine that we can buy a maximum of 16 puts at 0.15 for us to give this trade a fair shot (16 puts x 0.06 stop out = $96).
This number of contracts is lined up with our $100 stop loss control that we set for ourselves. It's important to adjust that stop loss according to what level of loss you are comfortable with and how many trades you plan on taking. If you planned on only taking one trade for example, you could double the number of contracts to 32 and that would give you the max loss tolerance we decided on earlier in this example ($200).
Once we enter the trade, we are able to set our stop and just comfortably know that one of two things will happen.
- We will stop out for a loss of $96 (pre cost)
- We will ride this trade as long as our stop does not get hit
Once you enter the trade and it starts to work in your favor, it is important to realize that you must adjust your stop as it works in your favor. An easy way to do this is to simply go in and move your stop loss setting from 0.09 up as the trade goes in your favor.
Let's say (as this was the case) this trade worked out for you and it went smoothly. If you find it in a position where it has doubled, you are welcome to take the cost of the trade off the table and allow it to run as long as possible. So simply put, once you see the options have gone from 0.15 to 0.31, you can take 1/2 of them off and move your stop down above your original entry. This will ensure that you have the maximum ability to capture the largest move possible. From that point on, simply look at the chart and plot upcoming targets where the stock may bounce and keep track of how it performs at those levels. Continue to adjust your stop higher and higher (options price) as it works in your favor.
In the case of BABA, the stock behaved perfectly in line with the chart itself as 75.9 and 75.5 functioned as support before ultimately the stock bounced at the 200D.
Above are the charts I posted in real time on stocktwits as the breakdown was happening. This is a basic risk tolerance calculation method that you can replicate with any stock and in any scenario to attempt and achieve a max risk/reward in your favor.
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