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Position Sizing With Options – Size ALWAYS Matters

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Introduction

 

 

 

Some investors allocate a small portion of their portfolios to options trading, because options are risky. This is because they involve a high degree of leverage.

Leverage allows investors to control a large amount of a security with a small initial investment. However, this increases risk because leverage-induced losses could be large and add up quickly.

With options, investors usually leverage or control 100 shares of a security per contract by paying a small premium relative to the stock price.

But there are ways of minimizing the risks of leverage, such as position sizing.

Position sizing answers the question: How many contracts should I buy or sell?

To answer this question, investors need to consider the risk and reward profiles unique to different option strategies.

In this lesson, we’ll discuss these risks and rewards and then run through position sizing examples for three common option strategies, long calls, long puts, and covered calls to give you a better understanding of how position sizing with options work.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Position Sizing Long Calls & Puts

 

 

 

Let’s start with long calls.

This strategy has unlimited potential reward, because a security can rise an unlimited amount (It should be noted that a stock price can “theoretically” continue to rise forever – although it’s not very likely that a price will consistently rise to a value, such a $1 million, per se – but in idea and theory, the potential for future profits is infinite).

The risk of long calls is limited, because an investor can only lose the premium they paid for buying the call.

A long call, or put option position, places the entire cost of the option position at risk. Should an individual long call or long put position expires worthless, the entire cost of the position would be lost.

 

 

Long puts also have high profit potential, but are limited because a security can only fall to zero. Like long calls, the risk of long puts is limited to the premium paid for the option.

When it comes to position sizing long calls and long puts, some investors weigh premiums against portfolio size.

For example, suppose an investor has a $25,000 portfolio and allocates a small portion to trading options.

A reasonable position size for a long call or long put trait might about be 1% of the overall portfolio, which in this case is $250.

Keep in mind that options contracts typically control 100 shares of a security. So to find the total premium, multiply the premium by 100.

For example, if a long call is selling for $2.50, the investor could buy one contract (Remember 1 contract = 100 shares of stock. So if 1 option contract is selling for $2.50, it will actually cost $250 – $2.50 x 100).

If a long put is selling for $1.25, the investor could buy two contracts.

 

 

 

In each of these trades, the premium paid is $250 plus transaction costs, or about 1% of the overall portfolio.

The investor risks losing the entire premium, which is $250 plus transaction costs – but the trade off is potential profits.

Limiting long calls and long puts to 1% of a portfolio allows for potential rewards, and helps keep risk in check.

Now that you understand how to position size long calls and long puts, lets move on to covered calls.

 

Position Sizing Covered Calls

 

 

Position sizing works differently for covered calls, because the strategy involves owning an underlying security and simultaneously selling a call option.

The maximum profit is the strike price minus the purchase price of the security, plus the premium received from selling the call less any commissions and fees.

The maximum risk is essentially the same as owning a security, which is that a security can drop to zero and lose all value.

 

 

This ownership risk is reduced by the amount of the premium received from selling the call, less any commissions and fees.

Any downside protection provided to the related stock position is limited to the premium received, less transaction costs.

The limited profit potential and high risk of covered calls presents a challenge when position sizing.

Investors typically take two different approaches to this challenge: They’ll either sell covered calls among the diverse group of individual securities, or limit covered calls to a single, broadly diversified security, like one representing an index.

Selling covered calls on different securities in a portfolio helps reduce the high risk of the strategy. However, this requires owning a larger variety of securities and could be cost ineffective.

A more cost effective approach is limiting covered calls to a broadly diversified security – as this type of security is likely to be less volatile and can reduce the risk of selling a covered call.

 

 

When position sizing covered calls, most investors sell one call per 100 shares of the underlying security.

For example, if an investor owns 500 shares of a broadly diversified security, they might sell 5 covered calls.

Position sizing this way helps balance high risk against limited reward, while trying to keep costs in check.

Although options are risky, proper position sizing can help manage the risks in the unique opportunities offered by these strategies.

 

 

Quick Recap

In Review….

Position Sizing Options

 

  • Some investors allocate a small portion of their portfolios to options trading, because options are risky. This is because they involve a high degree of leverage
  • Leverage allows investors to control a large amount of a security with a small initial investment. However, this increases risk because leverage-induced losses could be large and add up quickly
  • With options, investors usually leverage or control 100 shares of a security per contract by paying a small premium relative to the stock price
  • Keep in mind that options contracts typically control 100 shares of a security. So to find the total premium, multiply the premium by 100
  • Position sizing this way helps balance high risk against limited reward, while trying to keep costs in check
  • Although options are risky, proper position sizing can help manage the risks in the unique opportunities offered by these strategies

 

Position Sizing Long Calls

 

  • This strategy has unlimited potential reward, because a security can rise an unlimited amount (It should be noted that a stock price can “theretocially” continue to rise forever – although it’s not very likely that a price will consistently rise to a value, such a $1 million, per se – but in idea and theory, the potential for future profits is infinite)
  • The risk of long calls is limited, because an investor can only lose the premium they paid for buying the call
  • A long call, or put option position, places the entire cost of the option position at risk. Should an individual long call or long put position expires worthless, the entire cost of the position would be lost

 

 

Position Sizing Long Puts

 

  • Long puts also have high profit potential, but are limited because a security can only fall to zero. Like long calls, the risk of long puts is limited to the premium paid for the option

 

Position Sizing Long Calls & Puts

 

  • When it comes to position sizing long calls and long puts, some investors weigh premiums against portfolio size
  • In each of these trades, a premium is exchanged between the buyer and the seller – as this is the max amount you can receive from a trade minus any commissions and fees. However, the trade risks the entire premium in addition to transactions costs
  • This is why you must determine proper position sizing before entering a trade. To do this, you must first determine how much of your portfolio you are willing to risk if the trade were to go against you.
  • Most traders typically, allocate about 1-5% to a single option position – although to be on the safe side stick with 1-3%

 

Position Sizing Covered Calls

 

  • Position sizing works differently for covered calls, because the strategy involves owning an underlying security and simultaneously selling a call option
  • The maximum profit is the strike price minus the purchase price of the security, plus the premium received from selling the call less any commissions and fees
  • The maximum risk is essentially the same as owning a security, which is that a security can drop to zero and lose all value
  • This ownership risk is reduced by the amount of the premium received from selling the call, less any commissions and fees
  • Any downside protection provided to the related stock position is limited to the premium received, less transaction costs
  • The limited profit potential and high risk of covered calls presents a challenge when position sizing
  • When position sizing covered calls, most investors sell one call per 100 shares of the underlying security

 

Investors Choose To Position Size Covered Calls Using Two Methods

 

1. Sell covered calls among the diverse group of individual securities

  • Selling covered calls on different securities in a portfolio helps reduce the high risk of the strategy. However, this requires owning a larger variety of securities and could be cost ineffective

2. Limit covered calls to a single, broadly diversified security, like one representing an index

  • A more cost effective approach is limiting covered calls to a broadly diversified security – as this type of security is likely to be less volatile and can reduce the risk of selling a covered call

 

 

And this is how you would implement position sizing into your investing portfolio. Position sizing for options is exactly the same as position sizing for stocks; you must first determine the max risk you are willing to take on for a single position and allocate it according to the value of your portfolio.

 

If you are unsure of how to accurately position size your investments, take a look at our lesson in position sizing in more detail:

Portfolio Position Sizing – Accurately Measuring Your Positions

 

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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