by Ian Harvey
Determining Correct Options Size is Important!
There are actually several different ways of determining the correct options size, but I have found the ones below to be the most useful. Also, I often apply this method into 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.
Before Discussing Correct Options Size - Remember These Option Trading Tips:
1) A stock option is usually bought at a significantly lower price than the actual price of the underlying asset, so you don’t have to put up as much money to control the same amount of shares as if you were buying the underlying asset. This is one of the reasons why I use options rather than the underlying asset.
2) Because of the tremendous amount of leverage and the amount of shares you can control with options, you have to be extra careful. There are many components to the pricing of options. Keep in mind that over ninety percent of option contracts expire worthless so if you are thinking of putting your entire account in one option contract, then you might not have an account in the future.
3) The market trend will usually dictate which type of stock option to buy. If the market is in an uptrend, you would look to buy calls. Alternatively, if the market is in a downtrend, then you would look to buy puts.
How Much Should You Invest in Each Option?
Determining the right options size is critical for successful investing. Here's how you can determine the right position size for you.
Let's say you would normally invest $10,000 in a stock. If stock XYZ was trading at $50 per share, 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 options 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 OK, as long as you have plenty of time.
In other words, if the stock collapses for whatever reason, your option will take a thrashing. 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 discontinue the trade at a specified dollar loss, then you can still keep your losses to your preferred worst case scenario amount.
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 your account would never get into trouble.
It takes discipline to determine the correct options size. 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 options purchase for a stress-free trade.
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