Position Sizing

Position sizing is the single most important factor in long-term trading success. A mediocre strategy with excellent position sizing will outperform an excellent strategy with poor position sizing. Every blown-up account in history was a position-sizing failure, not a strategy failure.

The Core Principle

No single trade should have the power to significantly damage your account. If one trade can cost you 10% of your account, you are one bad week from being down 30% to 40%. At that point, you need a 67% gain just to get back to even. That hole is almost impossible to climb out of.

The rule: risk no more than 1% to 2% of your account on any single trade.

On a $50,000 account, that means max loss per trade of $500 to $1,000. On a $100,000 account, $1,000 to $2,000.

Calculating Position Size for Credit Spreads

Step 1: Determine your max risk per trade. Account: $50,000. Risk: 2% = $1,000.

Step 2: Determine the max loss per contract. You sell a $5-wide bull put spread for $1.50 credit. Max loss per contract: $5.00 - $1.50 = $3.50 ($350).

Step 3: Divide max risk by max loss per contract. $1,000 / $350 = 2.86. Round down to 2 contracts.

Result: You trade 2 contracts of the bull put spread. Max loss: $700.

Calculating Position Size for Iron Condors

Same principle. Account: $50,000. Risk: 2% = $1,000.

Iron condor on SPY: $5-wide wings, $1.60 total credit. Max loss: $5.00 - $1.60 = $3.40 ($340 per contract).

$1,000 / $340 = 2.94. Trade 2 contracts. Max loss: $680.

Calculating Position Size for Short Strangles

Undefined-risk trades need a different approach. There is no "max loss" because risk is theoretically unlimited.

Method: Use the expected loss at 2x credit as your sizing number.

Short strangle credit: $8.00 ($800). Your management rule says close at 2x credit ($16.00). Expected loss if stopped: $800 per contract.

$1,000 / $800 = 1.25. Trade 1 contract.

Some traders use the stress-test loss (portfolio margin's calculated worst case) as the sizing number instead. Either approach works — the point is to have a defined number.

Portfolio-Level Sizing

Individual position sizing is necessary but not sufficient. You also need portfolio-level rules.

Total portfolio risk: No more than 25% to 30% of account value in total max loss across all positions.

On $50,000: max total risk = $12,500 to $15,000.

If you have 10 positions at $1,000 max risk each, that is $10,000 total risk (20% of account). Good.

If you have 15 positions at $1,000 each, that is $15,000 (30%). You are at the limit.

Sector concentration: No more than 3 positions in the same sector. If you have put spreads on AAPL, MSFT, and GOOGL, you are at your tech limit. The next trade should be in financials, healthcare, or another sector.

Correlated positions: In a market crash, "different sectors" still drop together. Maintain 30% to 50% of your buying power as cash or hedges to survive correlated drawdowns.

The Kelly Criterion (Simplified)

The Kelly Criterion is a mathematical formula for optimal bet sizing. Full Kelly is too aggressive for options trading, but Half Kelly is useful as a sanity check.

Formula: Kelly % = (Win Rate x Average Win - Loss Rate x Average Loss) / Average Win

Example:

Win rate: 70%
Average win: $60
Average loss: $180

Kelly % = (0.70 x $60 - 0.30 x $180) / $60 = ($42 - $54) / $60 = -0.20

Negative Kelly means this specific trade setup has negative expected value. Do not trade it at any size.

Better example:

Win rate: 72%
Average win: $70
Average loss: $140

Kelly % = (0.72 x $70 - 0.28 x $140) / $70 = ($50.40 - $39.20) / $70 = 0.16

Full Kelly says risk 16% per trade. Half Kelly says 8%. Most traders should use Quarter Kelly (4%) or less. The 1% to 2% rule is conservative but survivable through extreme drawdowns.

Scaling Position Size

As your account grows, your position sizes grow proportionally. But do not increase size during winning streaks.

Recalculate quarterly, not daily. If your account goes from $50,000 to $55,000, do not immediately increase all positions. Wait until the end of the quarter and adjust.

Reduce size after drawdowns. If your account drops from $50,000 to $45,000, immediately reduce position sizes. Your 2% risk is now $900 instead of $1,000. This prevents the drawdown from accelerating.

This is the key insight: position sizing should slow you down during losses and speed you up during gains. It is a natural volatility brake.

Common Sizing Mistakes

"It is a high-probability trade, so I will size up." High probability does not mean guaranteed. A 90% probability trade still loses 10% of the time. If that one loss is 10% of your account, it wipes out many winners.

Sizing based on max profit instead of max loss. "I can make $500 on this trade" is not relevant to sizing. "I can lose $1,200 on this trade" is what matters.

Not accounting for correlation. Five bull put spreads on five different tech stocks are essentially one big bet on tech. If the sector drops 5%, all five lose simultaneously.

Increasing size after a losing streak. "I need to make it back." This is how small drawdowns become account-ending drawdowns. After a losing streak, reduce size or take a break.

Using margin as an excuse to oversize. More buying power does not mean you should use it. Size based on account equity, not buying power.

A Position-Sizing Checklist

Before every trade, answer these questions:

What is my max loss on this trade? (Including worst-case slippage)
Is that max loss under 2% of my account?
What is my total portfolio risk after adding this trade? (Under 25%?)
Am I already at my sector limit?
Would I be comfortable holding this position through a 5% market drop?

If any answer is no, reduce the size or skip the trade. No setup is good enough to justify oversizing.

Next: understanding your portfolio's aggregate risk through portfolio Greeks.