You Can Be Successful with a Winning Percentage of Under 50%
The principles of money management in options trading cannot be mastered without a firm grasp of the statistical probabilities involved. In his esteemed book, Trading for a Living, Dr. Alexander Elder sums up the importance of this concept in a word – innumeracy. According to Dr. Elder, “Innumeracy – not knowing the basic notions of probability, chance, and randomness – is a fatal intellectual weakness in traders.”
Renowned investing and trading coach Dr. Van K. Tharp addressed the issue of winning percentages in the November 1997 issue of Technically Speaking
, the newsletter of the Market Technicians Association. In his article, “Why It’s So Difficult for Most People to Make Money in the Market,” Dr. Tharp states, “Most of us grew up exposed to an educational system that
brainwashes us with the idea that you have to get 94‑95% correct to be excellent. And if you can’t get at least 70% correct you’re a failure. Mistakes are severely punished in the school system by ridicule and poor grades,
yet it is only through mistakes that human beings learn.
Contrast that with the real world in which a .300 hitter in baseball gets paid millions. In fact, in the everyday world few people are close to perfect and most of us who do well are probably right less than half the time. Indeed, people have made millions on trading systems with reliabilities around 40%.”
It should be noted that Dr. Tharp is not specifically referring to options trading in his discussion of winning percentages. In fact, you should expect winning percentages for option premium buying to be lower than that for trading stocks or futures. Our research shows that successful short-term options traders are correct on roughly 35% to 45% of their trades. Although this win rate may seem rather low, there are factors such as fighting time decay and preserving capital by shutting down losing trades beyond a certain point (some of which may ultimately have been winners) that are particularly relevant to options trading. The important point is that positive overall returns over the longer haul result from allowing your profitable trades to run and cutting your losses in other trades relatively quickly.
The concept of limiting losses and letting the winners run cannot be overstated. In his classic work, The Battle for Investment Survival
, Gerald Loeb states, “Accepting losses is the most important single investment device to insure safety of capital. It is also the action that most people know the least about and that they are least liable to execute ... The most important single thing I learned is that accepting losses promptly is the first key to success.” In addition, Loeb says, “The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.”
Losing is Part of the Game
An offshoot of this lower winning percentage, and something that often comes as a surprise to many traders, is the experience of a losing streak. Profitability requires great care to be taken to control the amount of capital allocated to each position, as even successful traders are not immune to a string of losing trades. Proper money management techniques allow you to weather the inevitable storms of losing trades.
Thus, given the high probability (and in some cases, certainty) of losing streaks within a given period, it is critical to realize that investors who place too much capital into successive recommendations run the risk of decimating their trading account during a perfectly normal trading cycle. In other words, they will be unable to stay in the game. Those that are able to stay in the game and reap the rewards of the hot streaks and higher returns of winning trades stand a better chance of ultimate profitability over the longer haul.
The moral of the story is that even though low winning percentages and long losing streaks are part of the options buying game, profitability is achievable if you let winners run and cut losses short (that’s our job), while staying in the game by using proper money management principles (that’s your job).