Determining the Correct Position Size with Options
Source: Kevin Matras, Zacks Investment Research (10/10/11)
"If you can manage your downside, the profits will take care of themselves."
There are actually several different ways, but I have found the ones below to be the most useful. Plus, it's what I do in my own trading.
As you know, you can get started in options with only a fraction of the amount of money you would normally need to invest in the stock itself.
But if you put in too little, it will hardly make a difference in your account if you're right. Put in too much and it'll put a big dent in your account if you're wrong.
How Much Should You Invest in Each Option?
Determining the right position size is critical for successful investing. Here's how you can determine the right position size for you.
For example: Let's say you would normally invest $10,000 in a stock. If stock XYZ was trading at $50 per share and that means you could buy 200 shares. And let's also say you were willing to risk 10% on the trade or $1,000.
Here's how to figure out your option size. One option essentially equals 100 shares. Two options equal 200 shares. If you buy one option at $500, under the worst-case scenario, your maximum risk would be what you paid for the option or $500. Two options would be $1,000. And that's the equivalent of risking 10% had you invested $10,000 in the stock.
Of course, that's assuming the worst-case scenario. Nobody intends to lose their entire premium. But it's a good idea to keep the worst-case scenario in mind when determining your position size as this is a foolproof way to manage your risk.
Sometimes you may need to buy a few different strikes to stay within that dollar amount. Instead of buying two $45 calls maybe you buy one $45 and one $47.50 call.
Of course, there will be times when you find yourself "needing" to spend a little more on quality options. That's okay, as long as you have plenty of time.
In other words, if the stock collapses for whatever reason, your option will take a drubbing. But, if there's lots of time on it, it will not go to zero overnight. So as long as you're disciplined enough to pull the plug at a specified dollar loss, then you can still keep your losses to your preferred worst-case scenario amount.
For example, if you purchased two great options for $700 each, that means your total cost/investment is $1,400. If those options ever lose a combined total of $1,000 (loss of -$500 on each), you'd sell them. And by doing this you're account would never get into trouble.
It takes discipline. But discipline is probably the most important skill in options trading. And if you can manage your downside, the profits will take care of themselves.
Put this method into practice on your next option purchase for a stress-free trade.
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our new Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.