Liquidity is Key to Optimal Trade Size

April 16, 2014
By Vlad Karpel

There are many variables involved in deciding the optimal size for a trade. The size of your account, capital available, tolerance for risk and trading goals are all important considerations.

Before we address these, though, let’s begin with a simple reminder: Liquidity, liquidity, liquidity.

Ease of exit is always more important than ease of entry. Seasoned traders and investors always avoid a “Roach Hotel” position, meaning that you can get in but you can’t get out. You can best judge an option’s liquidity by high volume, a tight bid/ask spread and a large open interest. Be sure that the size of the bid and offer is larger than your existing position. You want to be able to exit a position with one click and never step by step.

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A hedged investment position, such as a Collar (long stock, long out-of- the-money put, short out-of-the-money call), can be larger than a purely directional trade such as a vertical spread. After all, a Collar tends to be a good long term investment that is hedged against violent short term moves. As an aside, Collars are particularly attractive when the stock pays a hefty dividend.

A purely directional trade, on the other hand, will be either right or wrong in very short order and therefore should be relatively smaller.

Along those lines, a good rule of thumb is never to have more than 10 percent of available capital in any particular trade. This rule should be broadened to include all trades of a similar type. For instance, if you have three positions that all profit from a sharp downside move, those three positions combined shouldn’t add up to more than 10 percent of your available capital.

When it is a particularly risky position, such as a position that is short out-of-the-money credit spreads or net short options, then a 5 percent of available capital rule should apply.

Remember, in any purely speculative trade you must be willing to lose that money. It’s a trade and not an investment. An old saying goes, “Do not trade your investments and do not invest in your trades.” A corollary to that is never add to a losing position, never reinforce failure. “If you liked it at 20 you must love it at 15” is a great way to lose money.

Purely speculative trades with a relatively higher risk may even be placed in a separate account. This account should hold the minimum capital needed to carry the position. And, when that position wins, the profits should be immediately withdrawn so that money isn’t at risk with the next trade.

Another vital point to remember is that, while it is advisable to have no more than 10 percent of your capital in any one trade, that does not mean you should have many separate positions which combine to equal 100 percent of your capital. It is possible, however unlikely, that all the trades can move against you and wipe out your account. For that reason, it is therefore important that you keep some cash on hand—not only as a reserve, but to have the ability to seize a fresh opportunity.

You should never have a position greater than your comfort zone. If you lie awake at night worrying about a position, cut its size or close it out completely the very next day.

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