What is Convexity and What is Truncated Risk in Options Trading?

Risk Management in Options Trading

Convexity, when buying options, means your downside is capped and your upside is UNLIMITED. Truncated risk, when buying options, means that your risk is limited to your initial investment.

One of the primary advantages of the fixed fractional bet system  is the principle of convexity – playing more dollars on the way up, while fewer dollars are at risk after each losing trade.  On the downside, this system keeps you in the game longer by allowing you to weather the losing streaks that will inevitably occur.

For example, if you start with $25,000 and play the same $2,500 per trade, you will lose half your bankroll ($12,500) if you start off with 10 consecutive losses of 50% per trade.  While it is unlikely that you will have such a streak right off the bat, it is not beyond the realm of possibility.  However, the fixed fractional system has quite a different outcome.  In fact, this methodology comes out $2,468, or nearly 20%, ahead of the fixed investment approach, as shown below:

On the plus side, let’s assume you enjoy five straight winning trades of 100% apiece.  Investing $2,500 per trade will result in a portfolio of $37,500 (25,000 + 12,500).  On the other hand, the fixed fractional bet system results in a portfolio value of $40,263, or 7.3% better, as shown below:

In the real world, of course, you will encounter interspersed winners and losers, although the losers will most likely be more frequent .  As we have stated repeatedly, the goal of options trading is to keep afloat long enough to take advantage of the bigger winning trades and the winning streaks that will also occur.  And proper money management is the best way to play longer. 

As Smith states, “…risk management rules are really ways of dealing with the psychology of trading…[which] is the most important aspect of trading…discipline is the key psychological trait that the trader needs to make money.  Risk management rules are an effort at trying to enforce the necessary discipline.”

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