I write about this often because I think about it a lot. In fact, every time I open a position. I feel that proper management of trade risk is key to a traders’ success or failure. A complicating factor is that each trader has his/her own perception of acceptable risk. What I consider an “acceptable” risk may not be acceptable to someone else. One must realize that adjustments will be necessary to personalize any conclusion.
Early on, the trader is faced with the question, what risk is reasonable? Based on a maximum percentage of available risk capital? (Risk capital should include only funds that the trader can truly afford to lose – totally. Don’t risk the house payment, food budget or baby’s new shoe money.)
If one has $10k of risk capital, how much of that should one risk in a single trade? 5%? 10%? In making this consideration one quickly realizes that acceptable actual risk may give a trade risk so small that it is impractical, or unacceptable. For example a 5% actual risk of capital gives a trade risk of just $500 for a $10k account. Not having enough working capital may keep you on the sidelines more than you like. It seems very unfair, but it is definitely easier to make money if you already have a fair amount of it.
One may take some satisfaction from the fact that having a large available fund balance presents its own problems of risk allocation. What I think I’m saying is that no matter how successful most of us are, we will always have to deal with trade risk considerations.
I use a constant amount for trade risk for all my trades. This trade risk is maintained by adjustment of the quantity of options bought or sold. Periodically, the amount is adjusted up or down, depending on my success or failure in trading. As available funds increase/decrease, so does the trade risk.
When the trade risk starts to get big, that is good because it signifies that I've been making money. But it is probably a good idea to make a downward adjustment in trade risk. At some point I must consider adding strategies to my portfolio to ‘soak up’ the available funds. These added strategies, would have trade risk that considers the inherent risk of each strategy.
So as one becomes more and more successful, one will reach the point where funds which seem in ‘excess’ (yes, there actually is such a thing) would be moved to a different trading account and traded using an entirely different strategy involving less risk, and less trade maintenance attention. It should be every trader’s goal to be in the position of having ‘excess’ funds.