It is a good idea to develop a money trading (money allocation) strategy before jumping into options trading. Even a good trading system can become fatal when used in the wrong way. Below you will find a few reasons why we recommend that you do a few calculations before beginning to implement any trading system.
When a trader buys an option contract, he or she controls 100 shares of the underlying securities. Because of this leverage, option trading is one of the most attractive investment methods to speculators. However, because of this leverage, option trading is considered to be one of the riskiest types of investments.
Because of the risk associated with options, it would be wrong to state that option trading is similar to stock trading and that stock trading strategies can be applied to options trading. When purchasing stocks, a trader may invest his entire portfolio in a single public company. It would be a good idea to diversify the investment. However, even when investing in a single company, the risk of losing the entire value of the portfolio is small because the odds that the company will file bankruptcy within a month and the price of the bought stock will drop to zero are relatively small. On the other hand, investing the whole portfolio in options could "kill" the portfolio - if the options purchased are worthless when they expire, all invested money will be lost. Because of the higher trading risk, it is wrong to apply stock investment strategies (money allocation strategies) to options and it is a very poor idea to invest all of one's money in options.
There are two very popular option investment strategies (money allocation strategies) used by traders. One of these strategies involves investing a predetermined, fixed dollar amount in each trade. Another strategy invests a predetermined, constant percentage of the portfolio in each trade. These two investment strategies can be used in stock trading as well. By doing some math, we are able to see the advantage that use of these money allocation trading strategies has over investing an entire portfolio in options trading.
Let's assume that a trader uses a trading system that on average has two +30% profitable trades and one 50% loss. In summary, it is a trading system that yields a profit of +10% (2 * 30% = +60% profit minus a 50% loss). This doesn't sound bad. So, let's calculate 12 trades for each trading strategy.
Table #1: Entire portfolio invested in each trade. The initial portfolio size is $10,000
| Trade # | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $10,000 | -50% | $5,000 | -50% |
| 2 | $5,000 | +30% | $6,500 | -35% |
| 3 | $6.500 | +30% | $8,450 | -25% |
| 4 | $8,450 | -50% | $4,225 | -58% |
| 5 | $4,225 | +30% | $5,423 | -56% |
| 6 | $5,423 | +30% | $7,140 | -29% |
| 7 | $7,140 | -50% | $3,570 | -64% |
| 8 | $3,570 | +30% | $4,641 | -53% |
| 9 | $4,641 | +30% | $6,033 | -40% |
| 10 | $6,033 | -50% | $3,017 | -70% |
| 11 | $3,017 | +30% | $3,922 | -61% |
| 12 | $3,922 | +30% | $5,098 | -49% |
As you can see, the first lost trade has made unfixable damage to the portfolio and the +10% profitable trading system has resulted in a loss of half of the portfolio after 12 trades with this trading strategy. With this strategy, the bigger the losing trade, the greater is the damage done to the portfolio, and a 100% losing trade (very real in options trading) takes the entire portfolio down to the bottom zero line. This trading strategy is not recommended for options trading.
Table #2: $1,000 are invested into each trade. The initial portfolio size is $10,000
| Trade # | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $1,000 | -50% | $9,500 | -5% |
| 2 | $1,000 | +30% | $9,800 | -2% |
| 3 | $1,000 | +30% | $10,100 | +1% |
| 4 | $1,000 | -50% | $9,600 | -4% |
| 5 | $1,000 | +30% | $9,900 | -1% |
| 6 | $1,000 | +30% | $10,200 | +2% |
| 7 | $1,000 | -50% | $9,700 | -3% |
| 8 | $1,000 | +30% | $10,000 | 0% |
| 9 | $1,000 | +30% | $10,300 | +3% |
| 10 | $1,000 | -50% | $9,800 | -2% |
| 11 | $1,000 | +30% | $10,100 | +1% |
| 12 | $1,000 | +30% | $10,400 | +4% |
From the table above, we see that the strategy of investing a predetermined fixed amount in each trade protects the system from big losses. With use of this strategy even a trader is able to recover from the losses (even from a trade that results in a loss of 100%) if the trading system used delivers an overall positive average return.
Table #2: 10% of the portfolio is invested into each trade. The initial portfolio size is $10,000
| Trade # | Amount Invested | Trade Profit | Portfolio value | Portfolio Profit |
| 1 | $1,000 | -50% | $9,500 | -5% |
| 2 | $950 | +30% | $9,785 | -2% |
| 3 | $978 | +30% | $10,079 | +1% |
| 4 | $1,008 | -50% | $9,575 | -4% |
| 5 | $958 | +30% | $9,862 | -1% |
| 6 | $986 | +30% | $10,158 | +2% |
| 7 | $1,016 | -50% | $9,650 | -3% |
| 8 | $965 | +30% | $9,939 | -1% |
| 9 | $994 | +30% | $10,237 | +2% |
| 10 | $1,024 | -50% | $9,726 | -3% |
| 11 | $973 | +30% | $10,017 | +2% |
| 12 | $1,002 | +30% | $10,318 | +3% |
This strategy is very similar to investment strategy #2. It protects the portfolio from big losses, but has some compound effect and, with only small losses, can deliver greater profit over a longer period of time than the second strategy. At the same time, with big size losses, this strategy is less profitable than strategy #2.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.