Relationship Between Position Size and Trading Psychology-Options Trading for Dummies

After all of the math, you have to keep a consistent theme in mind: Risk management and money management are key to mitigating the negative emotions that cause so many traders to fail. You simply cannot talk about risk management without addressing psychology and you cannot talk about psychology without tying it back to risk management.

The idea with proper position sizing is that you are trading small enough to remove your emotions from the equations. And no matter how emotionally strong you think you are, the negative emotions of fear and
greed will find their way into your trading. Therefore, the newer you are,the smaller the positions you should trade. Don’t worry so much about winning as a new trader; just worry about not losing.

The idea is to get the technique down and the wins will come. But if you start chasing big money right away and taking on positions that are bigger than you can handle, the negative emotions will eat you alive.Handling Unexpected Market Volatility:Especially when trading instruments like gold, oil, and currencies, it is extremely important to pay attention and know how you will handle unexpected market volatility cause by economic data releases and unforeseen news events.

This is always something that you must decide before starting to trade your system with live money. And this is especially true if you are planning to trade a technical system.Many traders start trading systems that are purely technical, and they take on bigger positions than they should be taking on. When an economic data release comes out that moves the market, the trader’s systems don’t account for it and the data release can literally wipe out their entire account.

So the first and most obvious practical rule to mitigating the impact of unforeseen news events on your account is proper risk management. Once you have this in place, there are a few questions that you need to answer.First, will you hold positions while economic data releases are coming out? For example, let’s assume that you are trading a binary options short volatility system.

Are you going to stay in your trade during the nonfarm payroll economic data release? This is something that you have to test for and demo trade before deciding on how to proceed with live money.However, when you are trading a volatility long system, the economic data release can work to your advantage. This is because with a volatility long system you are actually banking on a big move in one direction or another.

Certain technical traders believe that the economic data releases and news are already priced into the market and simply choose to ignore the news and economic data releases. If you choose to do this, it is even more important to maintain proper risk management and position sizing, as you can be almost certain that markets will make huge moves due to news releases.

Of course, the fact that you are trading binary options provides you with a certain safety net. This is due to the fact that with binary options, you are always fully collateralized and can never lose more than you put in. So no matter how huge a move the underlying makes in one direction or another,you are protected by the collateral that you put up on the binary option trade.For example, if you are trading vanilla put/call options with a volatility short strategy, you are essentially selling a call and selling a put.

If the market makes a huge move in one direction or another, there is no limit to how much you can lose. In fact, you can actually lose more than you originally deposited into your account since you are trading on margin.The image on the right of Exhibit 14.13 depicts the P&L of a short volatility strangle with binary options. The image on the left depicts the P&L of a short volatility strangle with vanilla options.

The x‐axis represents the price of the underlying, and the y‐axis represents P&L.Since binary options are fully collateralized, when doing a short volatility spread, you can never lose more than you allocate to a trade. For the long option, you can never lose more than the premium that you put up on the trade per contract, and for the short option, you can never lose more than $100 minus the option premium per contract.

Of course, this works against you with a volatility long strategy. When trading a volatility long strategy using vanilla put/call options, your upside is unlimited since the options are not capped at $100 at expiration. However,with binary options, no matter how much the underlying moves, your profit is limited to the option premium for short trades and to $100 minus the options premium on long trades.