What Does 'Trade Small' Actually Mean? Position Sizing for Defined Risk

Key Concepts

• Defined Risk Strategies: Options strategies with a capped maximum loss (e.g., Iron Condors, Vertical Spreads, Butterflies).
• Undefined Risk Strategies: Options strategies with potentially unlimited loss (e.g., Short Puts, Short Strangles, Ratio Spreads).
• Net Liquidating Value (NLV): Account value used for calculating position size.
• Position Sizing: Determining the appropriate amount of capital to allocate to each trade.
• Volatility Premium Selling: A trading approach focused on selling options to profit from volatility decay.
• Greeks: Measures of sensitivity of an option's price to various factors (e.g., delta, gamma, theta).

Defined Risk Strategy Position Sizing at TastyTrade

This discussion centers around position sizing for defined risk options strategies, a core tenet of the TastyTrade trading philosophy – “trade small and trade often.” The emphasis is on allowing probabilities to play out over time rather than relying on winning a single, large trade.

Defined Risk vs. Undefined Risk Strategies

The speaker begins by framing the discussion within the broader context of defined versus undefined risk strategies. While most traders utilize a combination of both, the benefits of each are distinct.

Undefined Risk Strategies (e.g., short puts, short strangles, ratio spreads) offer:

• Higher probabilities of profit.
• Unfiltered exposure to the “Greeks” – allowing for nuanced adjustments.
• Easier trade management through rolling or transforming the position.

However, they carry the risk of potentially unlimited losses, requiring significant skill to manage adverse movements.

Defined Risk Strategies (e.g., iron condors, vertical spreads, butterflies) provide:

• A known maximum loss on entry, offering psychological comfort.
• Pre-planned risk acceptance, reducing emotional trading.

Optimal Position Sizing for Defined Risk

The core recommendation is to allocate 1% to 3% of your Net Liquidating Value (NLV) to each defined risk position. This sizing allows the probabilities inherent in the strategy to materialize over a series of trades, weeks, and months.

Examples:

• $50,000 Account: Position size should range from $500 (1%) to $1,500 (3%).
• $100,000 Account: Position size should range from $1,000 (1%) to $3,000 (3%).

Consistency within the chosen range is stressed. Sticking to a consistent percentage (e.g., always 1.5%) simplifies tracking performance and evaluating the strategy’s effectiveness.

Adjustments Based on Account Size

The 1-3% guideline isn’t rigid. Adjustments are recommended based on account size:

• Smaller Accounts ($5,000 - $10,000): May require exceeding the 3% limit (4% or 5%+) due to limited capital. This is presented as a necessary concession.
• Larger Accounts ($150,000+): Can comfortably operate below the 1% range (0.5% or 0.25%) while still maintaining economically significant position sizes. Larger capital bases provide a built-in advantage for trading small and often.

The Importance of Small Sizing: Lessons from Experience

The speaker emphasizes that position sizing is often overlooked but is a critical factor in trading success. Experienced traders consistently identify oversizing as a primary source of their biggest mistakes, regardless of the specific strategy or market.

As stated by the speaker, “Some were on the long side, some were on the short side, some were individual stocks, and some were indexes. But the one common denominator across almost every single one is they were sized too big.”

Logical Flow & Connections

The presentation logically progresses from defining the core philosophy of “trade small and trade often” to differentiating between defined and undefined risk strategies. It then focuses specifically on position sizing for defined risk, providing concrete guidelines and adjustments based on account size. The concluding point reinforces the importance of disciplined position sizing based on the collective experience of successful traders.

Conclusion

The key takeaway is that disciplined position sizing – allocating 1-3% of your net liquidating value to each defined risk trade – is crucial for long-term success in options trading, particularly when employing a high-probability, premium-selling strategy like those favored at TastyTrade. Trading small allows probabilities to work in your favor over time, mitigating the impact of individual losing trades and fostering a more sustainable trading approach.