Determining proper trade size can be difficult for defined and undefined risk trades. If your trade size is too small relative to your account, you won't make any money. Conversely, if your trade size is too large relative to your account, you will likely lose all of your capital. In trading, using proper trade size is a crucial step to ensuring we live to trade another day.

While a trade's margin requirement is a decent gauge of the risk involved, there is much more we can consider when deciding whether a trade is too big for our account. When it comes to defined risk trades on equities, the margin requirement will be equal to the maximum loss of a position. Depending on the probability of success for a defined risk trade, we can estimate the probability of having a certain number of losers in a row.

For example, if the probability of success on a defined risk spread is 67%, we should lose 1 in every 3 trades over time. If we place 33% of our account in three uncorrelated trades with a 67% probability of success, we have a .33^3 chance of losing all of our money. The probability of this occurring comes out to about 1 in 28. If we are trading actively, this is quite likely! From this analysis, we can safely say that putting 33% of our account in trades with a 67% probability of success will eventually leave us with no capital left to trade.

On the other hand, if we put 5% of our account into independent trades with a 67% probability of success, we must lose 20 trades in a row to get wiped out. The probability of this is 1/[.33^(20)] = 1 in 4.25 billion. As you can see, by reducing our capital allocation in each trade (still with 67% probability of success), we have a significantly higher likelihood of not losing all of our capital.

For undefined risk trades, the margin requirement is what we must put up to cover potential losses on the position. However, the margin requirement for undefined risk trades is not the maximum loss we can incur on a position, which is why looking at margin alone is dangerous. Brokerage houses commonly define undefined risk at a 2 standard deviation move. This means that with 95% certainty, the loss on an undefined risk position will not exceed a given amount. For the most part, the margin on an undefined risk trade will be larger than the loss after a 2 standard deviation move. However, there are times when this is not the case.

The segment provides examples of when the loss at 2 standard deviations is significantly more than the margin requirement, as is the case in oil. For example, with FEB oil futures trading at 63.50, the 1 standard deviation put is at the 55 strike, while the 2 standard deviation put is at the 49 strike. In oil, each point is worth $1,000, which means a move from 55 to 49 represents $6,000. The margin requirement to sell the naked 55 put is approximately $1,900, while the risk to 2 standard deviations is approximately $6,000. In this case, our margin requirement does not come close to covering the 2 standard deviation risk, making a strong case for avoiding the trade if we aren't willing to accept the possibility of a $6,000 loss.

In conclusion, when we are trading defined risk spreads, it's a good practice to consider the probability of experiencing a full loss on a certain number of trades in a row. This can help us determine a proper position size for trades with a chosen probability of success. For undefined risk trades, it's important to be aware of the risk to 2 standard deviations, as this can be much higher than the margin requirement to initially put on the position. In addition, be aware of the fact that the margin requirement for undefined risk trades will increase as the volatility of the underlying increases, and/or the underlying moves towards our short strike. In other words, the margin for undefined risk trades is subject to change often, and it's a great idea to keep capital available to account for adverse changes in margin.