Option Position Sizing

Option Position Sizing: How Much to Invest In Each Option Trade

By Karim Rahemtulla, Advisory Panelist
Thursday, July 28, 2005: Issue #229

One of the most frequently asked questions from subscribers concerns option position sizing and how much to allocate to each trade.

While the following answer may not be the “clearest” in the world, it should give you a framework from which to base decisions.

What makes this question tough to answer is the obvious fact that each person has a different level of assets, financial sophistication and goals. It’s not like each member has the same income, is the same age and has the same retirement or spending habits.

My rule of thumb is this: Do not risk more than 4% of your investable assets in any one position. That is the starting point for anyone who does not have market experience.

If you are more familiar with the situation or strategy, then you should increase your investment accordingly, but not to more than 10%. Why 10%? Because that is personally the most I EVER risk on any one position. That is my comfort level, based on several years of investing experience and continuous market education.

How Much Can You Afford to Lose?

The amount to invest is just the beginning. The second part of the story is how much you can afford to lose if the position goes against you. Warren Buffett, an investor with vast experience, once said that you should not invest in anything if you were not willing to endure at least a 50% loss – before recovery or with no recovery.

My take is as follows. If you are trading stocks, your stop loss should be between 15% and 25%. The 25% number should be reserved for situations that are effected by non-direct issues – for example, a terrorist attack that effects the entire market but has no direct long-term implications for your individual stocks.

For options, you should use a much wider stop loss because of the leveraged nature of the beast and the lower dollars at risk.

Options Need Wider Stop Losses – MUCH Wider

For example, on my LEAPS picks we always begin with a 50% stop loss. Why? Look at it this way…

If I am investing $40,000 for 1,000 shares of a stock, and using a 20% stop loss, I am limiting my loss to $8,000.

If I bought a LEAP for $4 with two years to go, my total loss, IF I were to “lose everything,” would be $4,000, or half that of the stock investment. Of course, because of the time factor and the limited dollars at risk, I am willing be to be more liberal with some of the stop losses.

How Short-Term Options Render Stop Losses Useless

On a short-term option – one that expires in a couple of weeks or a couple of months – it is a crapshoot as far as I am concerned. And that being the case, a stop loss is usually useless. On the flipside, you should be investing the LEAST possible dollars on this type of trade, as it is, in my book, the most speculative trade you can make… albeit the one with the highest return potential.

The Secret to Position Sizing & Allocating Toward Whole Strategies…

As far as how much to allocate to an individual strategy, the answers are just as ambiguous. I will only speak to my strategies, The LEAPS Option Trader and The Income Trader – A Covered Call Strategy.

LEAPS: For the LEAPS trader, most picks are in the $2 to $3 range, with some under $1 and some over $3. We will use $2.50 as an average per-contract entry price.

We are after two types of wins in the LEAPS service. The first is a straight play – a buy and then a sell. In this type of play, I am looking for gains of 20 to 50% in the short term (less than six months on a one-year option, and 12 to 15 months on a two-year option). In this case, my recommendation is five to 10 contracts per trade, or a commitment of $1,250 to $2,500.

In total, the investment needed to participate fully in the strategy is about $15,000, assuming five to six open positions at any one time. Remember, that money would be equivalent to investing about $200,000 if you were to buy the underlying shares instead.

COVERED CALLS: For the covered call service, my guideline is between $5,000 and $10,000 committed to each trade. The more the better, as far as I am concerned…

So far this year we’re almost batting a thousand on our picks, with an average return of between 1% and 2% per month. As you can see, a lesser amount, say $2,000, would be affected adversely by transaction costs.

I estimate that transaction costs account for about $60 to $90 total so far this year for the covered call service. So, on a trade of $2,000, with a 12% return in six months, you would be netting $150 – not bad, but not much to write home about.

On $10,000, you would net more than $1,100 – not bad for six months with better-than-average downside protection…

In the end, position sizing and dollar allocation are subjective and depend on your financial position and goals.

What is not subjective is the actual act of investing your money. If that is not done objectively, then all the sage advice in the world will not help you.

Good Trading,

Karim