There’s an essential question I’ve been asked over and over again throughout the years from folks who are new to options trading. I was recently just asked this question again, so I wanted to address it here.
How much money should I put into each of your trade recommendations?
Let’s start the answer to that question with the obligatory disclaimer…
The answer depends on how you are as a trader/investor. Your age, net worth, risk tolerance, financial goals, income, and many more factors need to be considered. What’s right for one may not be right for another. So, you need to trade in amounts that are comfortable for you.
Now, having said all of that, let me share a few thoughts…
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Remember, the purpose of options is to reduce risk – not increase it. So, as a simple rule of thumb, you can trade one option contract for every 100 shares of stock you would normally trade.
If you normally buy 1,000 shares of stock, then buy 10 option contracts (or sell 10 uncovered options as per the recommendation). If you normally trade in lots of 500 shares, then five option contracts will do. Even if you start with just one option contract, that’s perfectly fine as well.
This is an ultra-conservative option strategy. It’s what I would tell my mother to do if she were new to option trading. You’ll never overleverage a trade this way, and you’ll never have one losing position blow up your account.
Now, if you’ve been trading options for a while – and are comfortable with them, can handle a more aggressive form of trading, and can be disciplined with your position sizes – then let me share with you how I basically trade my own portfolio.
The Conservative Option Trader’s Portfolio
Let’s say you have $100,000 in your trading account (you may have more or less, but using $100,000 makes the math simple).
Take $80,000 and set it aside for conservative trades like selling uncovered put options. The other $20,000 can be used for speculative option buying.
The basic idea here is to attempt to make enough money on the $80,000 conservative side of the portfolio to pay for any possible losses on the $20,000 speculative side. And, if you do well speculating, then you’ll add a nice windfall profit to your account.
Selling uncovered put options is a low-risk, conservative strategy. You get paid cash up front for agreeing to buy shares of stock you already like and at a discount. It’s one of my absolute favorite options strategies.
So, let’s first look at how to allocate the $80,000 in conservative uncovered put option trades…
Take the $80,000, divide it by 10, and you get $8,000.
That’s the most you will allocate to any one conservative trade.
I can’t ever recall a time when I had more than 10 uncovered put option positions at work at the same time. Usually, I have maybe four or five trades at work.
So, I almost always carry a large cash position. That comes in handy on those rare occasions – once or twice each year – when stocks reach truly extreme conditions, and I have lots of trading opportunities in front of me.
For the purpose of this example, I’ll allocate at most $8,000 (10% of the money I’ve set aside for this strategy) for each uncovered put position.
For example, one time I recommended selling the Citigroup (C) September 18 $50 uncovered put options for $1.65. The margin requirement for each option contract was $1,000 (that’s 20% of the purchase obligation to buy 100 shares of C at $50). If we divide $8,000 by $1,000, we get 8.
So, in this instance, I would be comfortable selling eight of the C puts. Of course, that means I have to be comfortable buying 800 shares of C – which I am. Your risk tolerance may be different, and you might choose a smaller position.
But, most folks SHOULD NOT take a larger position than this.
By selling eight of the C uncovered put options at the recommended price of $1.65, I’ll collect $1,320. And, if the option expires worthless – which is always the best outcome on an uncovered put trade – I’ll record a nice $1,320 profit on the trade.
So, if you’re not taking advantage of this strategy, then you’re missing out on some tremendous returns.
And, it’s those returns that help to fund the speculative side of the account…
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How to Speculate Without Risking It All
Buying speculative puts and calls is exciting. It’s thrilling to think about the potential of earning 100%, 200%, or more in just a few days. But, the reality is… Most folks who speculate with options lose money.
First of all, put and call options have the potential to expire worthless – meaning everything you put into the position goes to zero.
Plus, most folks overleverage their trades. They take on too large of a position. Then, when the trade goes against them, they wipe out their account… Don’t be that person.
Take, AT MOST, 20% of your account (in this example, $20,000), and set it aside for speculating. Divide that $20,000 by 10, and you get $2,000.
That is the absolute most you should put into any option speculation.
Similar to my uncovered put option trades, I don’t think I’ve ever had more than 10 speculative positions at work at any one time. Usually, I have three or four trades running, and I carry a large cash position.
Another example is the Beazer Homes USA (BZH) August 21 $10 call options I once recommended buying for $1.30. The absolute most you would buy is 15 options ($2,000 divided by $130).
Now, frankly, I might even be more conservative than this and limit the trade to $1,000 or $1,500. But, even if you take the $2,000 position, the most you’re risking of your total account is 2%.
If you’re wrong, it’ll hurt to lose $2,000. But, it’s not going to wipe you out. And, if you’ve been selling uncovered put options, then your profits on those trades should make up for the loss on an errant speculation.
Buying calls and puts is a riskier strategy than selling uncovered put options. But, the rewards can be terrific.
The ideal strategy, though, at least in my experience, is to use the bulk of your trading account for conservative trades – like selling uncovered puts. Then, take the profits from that activity to fund a few speculative purchases.