How to Determine Position Size in Options
03/28/2012 8:00 am EST
Using sample accounts and risk parameters, Josip Causic shows how to select a position size that accommodates the trader’s own maximum-loss limits, helping them to trade while still preserving precious capital.
The topic of proper position sizing is of utter importance to any trader, option trader or not; therefore, we shall delve deeper into this subject and use several mathematical examples from the current market. The focus will be placed on both long calls and long puts, as the student who inspired this article asked.
There are several steps to an options trade:
- Fundamental analysis: What to trade
- Technical analysis: When to trade (timing)
- Implied volatility: Which option strategy to use
- Proper position sizing
- Entry and active monitoring
- Exit and learn from the trade
This article will focus on Step 4: Proper position sizing.
In order to delve deeper, we need to know the account size, and for simplicity’s sake, we will use two examples. The first account will have $50,000 in it and a trader that is willing to risk 2% of the account, or $1000 ($50,000 x 0.02). The second account is much smaller at $10,000 and the trader is more conservative, so the risk is only 1% of the account, or $100 ($10,000 x 0.01).
The formula for finding out the number of contracts is quite simple: divide the specific portfolio risk by the trade risk (cost of trade); we will go over this math three times.
Position Sizing for a Long Call
Assuming that technical analysis was properly done, and that reasons for a bullish entry are valid, we proceed to the readings of implied volatility (IV), which point out that the IV is in the lower range. Therefore, the premium is relatively inexpensive. From the option chain, we pull out the May cycle (72 days to expiry) and look for 70 cents Delta. The premium on the Ask for a May 30 call with a Delta of 76 is $2.41.
See related: Delta: The King of All Option “Greeks”
Once we know with certainty how much the May 30 call costs ($241 per contract), we can figure out the number of contracts we can purchase.
The first account with $50,000 and allowed risk of $1,000 (or 2%) qualifies for this trade because $1,000 divided by $241 equals four contracts that we can purchase (4.15 contracts rounded down).
The second account, which allows for a loss of only $100 (or 1%) does not work with this particular position sizing based on the max loss. (However, if an option trader still wants to take this trade, there is another way to handle the position sizing by placing the stop loss at an acceptable percentage of the premium value. This might be the topic of a future article.)
Position Sizing for a Long Put
Assuming that we want to short a stock that trades around $8, and the technicals and the IV reading (being in the lower range) support a long put purchase, then the same procedure applies. The May option chain with 72 days to expiry should be opened and the 70-cents Delta or higher should be selected.
The May 10 put with 72 cents Delta at the Ask costs $2.09, hence, the most a single contract could lose is $209. Of the two accounts, only the larger one qualifies. From $1,000 divided by $209, we get 4.78, so again, only four contracts.
These examples highlight how position sizing according to the max loss truly works. The total cost of the contracts was used as the base. Buying a single-legged call is riskier than spread trading, so keep in mind that spread trading with one lot (single contracts) can work well also.
By Josip Causic, instructor, Online Trading Academy