Trading options involves several key decisions: the expiration date, the strike price, and—perhaps most importantly from a risk management perspective—the size of your position. Here are some tips to help you make this choice.
Managing your risk
To illustrate why the size of your trade is paramount to managing risk, consider a hypothetical scenario where you have allocated a maximum of $1,000 to purchase a call option on a stock that you think will go up in value.
You might decide to invest all $1,000, or some fraction of that money. Simply put, you should never invest more than you are comfortable losing. In this scenario, if you aren't comfortable risking more than $500 on a particular trade, the maximum amount that you should consider putting at risk is $500.
Of course, you may not want to risk anywhere near the max amount that you are willing to lose, and each decision should be made within the context of your overall trading and investing plan. Generally speaking, most investors should only consider allocating a relatively small percentage of their overall portfolio to an options trade.
Unique risks of options
When it comes to deciding what the right size is for an options trade—compared with, say, a purchase of stocks or ETFs—the unique fundamentals of options dictate that you should take particular care. If you purchase a stock with $500, for instance, the most you can lose is $500.1 With options, some strategies allow you to know exactly how much money is at risk before entering into the trade, and some do not. Let's demonstrate why this is the case:
- If you buy call or put options, the most you can lose is the dollar amount that you spend. Suppose XYZ stock is currently trading at $50, and you purchased one call option contract on XYZ stock with a strike price of 53 at a premium of $5 per contract. The cost of this trade—which is equal to the maximum potential loss—is $500 ($500 = 1 call option contract * $5 premium * 100 shares per contract).2
- Alternatively, if you were to sell 1 call option contract, the most you can make is the premium received, but the most you can lose is unlimited. Let's say you sell 1 contract on XYZ stock with a strike price of 47 at a premium of $5 per contract. If the stock dropped to $45 during the life of the contract, and the option was not exercised, you would make money. However, if the stock rose to $55 during the life of the contract, you would lose $3 per contract, or $300 ($500 gain for selling the option minus $800 for the stock price rising $8 above the strike price). If the stock rose to $60 during the life of the contract and was exercised, you would lose $8 per contract, or $800, and so on. Hypothetically, there is no limit to how much you could lose when selling options.
These calculations become slightly more complex with other advanced strategies, such as spreads and straddles. Some strategies can help you mitigate some of your risk in exchange for accepting a lower potential return. Regardless, the amount of money you choose to invest depends primarily on your risk tolerance and partly by the strategy you choose.
While the appropriate dollar value of the trade should depend on your tolerance for loss (i.e., how much you are willing to lose), the size of your trade (i.e., the number of contracts) is determined by your tolerance for loss as well as the gain/loss potential per contract. The gain/loss potential per contract is largely determined by your choice of the strike price and expiration date.
For example, suppose you are willing to risk a maximum of $1,000 to buy call options on XYZ stock. Most options allow you to buy or sell calls and puts at many different strike prices. If XYZ stock is trading at $50, an in-the-money 40 strike price might cost $15 per contract, while an out-of-the-money 60 strike price might only cost $1 per contract.4
Consequently, it will cost you $1,500 to buy one call option contract at the 40 strike price, whereas it will cost just $100 to buy one call option contract at the 60 strike price. If you plan to invest $1,000, the dollar value of your position might be the same, regardless of the strike price you choose, but the number of contracts you own would differ depending on the strike price (e.g., 10 contracts for the 60 strike price vs. needing $500 more to buy 1 contract at the 40 strike price). Holding all else equal, the more contracts you own, the greater the potential reward and the higher the cost.
Fortunately, there are a variety of tools you can use to help make these decisions. They include:
The probability calculator, in particular, may be worth exploring—especially if you are interested in utilizing some advanced methods to determine options size (more on this shortly). Suppose you think XYZ stock is going to increase in value and, consequently, you’d like to buy XYZ call options. But how much do you think it will rise, and what is the likelihood that it might do so?
The probability calculator can help you determine the probability of XYZ trading above, below, or between certain price targets by a specific date. This can help you select the right strike price and expiration date based on your outlook, and this will dictate the size of your position. Based on these determinants, you can confirm if the strategy aligns with the amount of risk you are willing to take.
Hitting the right strike price
For advanced traders, there are additional methods that you might consider to help you think about choosing the right position sizes such as test driving approaches like the Kelly criterion and Optimal F.
Using one of these methods may be beneficial because it adds discipline to your trading and removes your emotions from the decision-making process. This helps you avoid guessing how much capital to allocate to your options trade. Edward O. Thorp, one of the first people to trade options on the Chicago Board Options Exchange (CBOE), is a practitioner of the the Kelly criterion—a formula that helps establish how much money to put at risk:
For example, suppose you have $1,000 allocated for an options trade. Using a probability calculator, you find that there is a 70% chance that a stock will hit a certain price by a specific date (70% would be the "win probability"). Based on this factor, the Kelly Criterion formula suggests you allocate 57% of your $1,000, or $570, to this trade. 57% is calculated as: .70 - [(1 - .70) / (.70/.30)].
Optimal F is another approach to consider. Optimal F is a mean that's based on historical results representing the percentage of your portfolio you want to use for each trade. Consequently, according to Optimal F, the number of shares to buy equals:
For example, suppose you have $50,000 in total investment funds, the percentage of those funds you are willing to risk is 50%, your optimal F (the percentage of your portfolio that you want to dedicate to a specific trade) is 5%, and XYZ stock is trading at $10 per share. The Optimal F formula suggests that you should buy enough contracts to purchase 500 shares of XYZ stock, or 5 options contracts. This is calculated as: [.05 * ($100,000 / 0.5)] / $10.
Of course, application of either of these methods requires a full understanding of the risks and limitations, and you should gain experience through practice before implementing either strategy.
Regardless of whether you incorporate options tools or advanced methods when deciding how much money to invest in an options trade, you should always stay within your risk tolerance. Have a plan that clearly defines your objectives and risk tolerance, and stick to it.