Last week, I discussed guidelines for position sizing stock trades – but that’s not a one-size-fits-all solution for limiting risk in your portfolio. Nothing is one size fits all when it comes to investing. You can adapt these guidelines to fit your personal style and work better for you.
I’ve traded options for more than 25 years, and one aspect of it that I always get asked about is how much to invest in a single options trade. Today, I will cover two types of options positon sizing strategies that together cover about 95% of the trades most investors place.
Put and call options are used in lieu of buying or selling the actual stock – so if IBM is trading for $140 per share, you can control the stock for about $10 per share using an option. However, keep in mind that options expire.
In this case, you would consider how much you would like to invest in IBM shares. If you wanted to buy 1,000 shares for $140,000, you would not invest that amount in an option. You would look at how much it would cost to control 1,000 shares at the $140 strike price.
In this case, it is $10 per option, or $1,000 per contract, because each contract controls 100 shares. To control 1,000 shares, it would cost you $10,000. That should be your maximum position size. Obviously, you are betting that IBM is going much higher. For you to break even on the trade, IBM would have to move to $150 or higher ($140 strike price plus $10 for the option).
By using the option, you are risking $10,000: 7.14% of the $140,000 it would have cost to buy the shares outright. However, this option expires in a year, so you have a defined period during which you must make a profit or you will lose all your investment. However, you will not be obligated to buy the shares.
A good position sizing rule of thumb for buying calls or puts is to buy one call or put per 100 shares that you would have purchased.
When it comes to put selling, you must think differently about position sizing. You must consider your exposure because put selling obligates you to buy the underlying shares if they close at or below the strike price (the price at which you agreed to buy them).
Let’s look at AT&T (NYSE: T), which is trading around $30. If your goal is to own 1,000 shares of AT&T for $30,000, then you would sell 10 puts at the $30 strike price. You would pick a price of about $3 per contract sold based on current prices and a January 2020 expiration.
Initially, you would receive $3,000 for selling 10 contracts. And if the shares closed at or below $30 at expiration, you would have to come up with $30,000 to buy them, but the $3,000 would lower your cost. If AT&T closed above $30, you would keep the $3,000, but you would not be obligated to buy the shares. You would then rinse and repeat!
The position sizing rule for put selling is the same as it is for buying the shares: Do not obligate more than 4% of your total investing portfolio to any one position. If your portfolio is worth $100,000, you could risk $3,000, meaning that you could afford to buy 100 shares of AT&T for $30 if you had to make the trade at expiration. This also means that you would sell only one contract because that would obligate you to buy 100 shares.
The biggest mistake people make is thinking that they will not get put. This leads them to “chase the premium.” Let’s say you are one of the “chasers.” If you sold 10 contracts, you would pull in $3,000 – but if you got put, you would have to come up with $30,000, or 30% of your $100,000 portfolio. That’s not a sign of smart investing.
Both options and stocks require you to be vigilant about position sizing. Ignoring this lesson will ultimately lead to much bigger losses for your portfolio, which will make for a very sad retirement.