How to Avoid Blowing Up Your Account

You will make bad trades. But there's no reason you must risk blowing your account to smithereens.

• Almost every blown account story can be traced back to the same widespread problem: trading too large.
• With defined-risk strategies, keep your max loss to no more than 1% to 3% of your total account value.
• With undefined-risk strategies, keep the Buying Power Requirement to no more than approximately 5% of your total account value.

I’ve been there. You’ve been there. Every trader has been there. As a rite of passage in the trading world, most traders get swept away in the excitement of the markets, let their emotions and overconfidence get the best of them. Eventually, they blow their accounts to smithereens. 

But it doesn’t have to be that way. There is one common denominator across every blown account story that reliably comes up over and repeatedly: position sizing. 

Simply put, it doesn’t matter how effective your strategy or set of strategies might be. They won’t always work, and if you size up too large on order entry, you’re going to learn an extremely expensive lesson. It doesn’t matter how much the probabilities might be in your favor, trade after trade. You will hit a streak of losers, and if you’re not small enough at trade origination, your portfolio is going to be bleeding red.

Defined-risk position sizing

Among the biggest benefits of defined-risk strategies, like vertical spreads or iron condors, is that you needn't be concerned about being on the hook for huge losses after a big, outlier move. The strategies also let you know with precision what your maximum loss on that trade could be.

If you sell a $3 wide vertical spread for $1, you know that the most you can lose on that trade is $2 (or $200 per lot). It doesn’t matter how much the stock might move against you. Your loss is capped at $2. Or if you sell a $5 wide iron condor for $2, you know that the most you can lose on that trade is $3 (or $300 per lot). Again, it doesn’t matter how badly you miss the mark on the stock move, your loss is fixed. Because of this, it’s extremely easy to get small enough on your defined risk trades and keep potential losses between 1% to 3% of your account value per trade.

Undefined risk position sizing

With an undefined-risk position, position sizing is a bit trickier. Your maximum loss on an undefined-risk position isn’t known on order entry—and it can’t be known. Since there is no limit to how high stocks can go, and even drops that are bounded by zero on the downside can be quite significant, it’s not possible to know your maximum potential loss on an undefined-risk position, like a short strangle or ratio spread.

However, we can approximate with a high degree of accuracy what a bad outcome would be likely to mean in terms of position drawdown. The buying power requirement (BPR) that must be set aside for an undefined-risk position tends to correspond with somewhere around a 5% likelihood of outcome. In other words, if you set up a short strangle with a $2,000 BPR, then the probability that you must absorb a $2,000 drawdown (or worse) in that position is around 5%. The probability that your drawdown will be less than that or you will make a profit is around 95%

Therefore, the BPR itself can be used as an approximation of your maximum loss on the position. Again, theoretically you can lose much more than this, and there will certainly be times in your trading career when your losses do exceed this level. But when it comes to sizing your undefined-risk strategies appropriately, it’s extremely helpful. Especially when keeping the size of your undefined-risk positions to around 5% of your account value is the best thing you can do to avoid blowing your account.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

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