got plenty of options strategies mapped.
Lots of choices using calls, puts,
vertical spreads, and more. But how much
should you risk on a given trade, or
be willing to risk at any point in time?
Something to consider is the concept of
utility of your trading capital.
$25,000 in your trading account, the 5%
rule says you should limit your risk on any
one trade to $1,250. So, if you have your eye
on an out-of-the-money (O TM) put worth
$2.10 (times the multiplier of 100, or $210),
you could buy six contracts for $1,260.
When selling vertical spreads or other
defined-risk options strategies, calculating
the risk is equally straightforward. It’s the
point of maximum loss, minus the amount
you’ve collected in premium, plus transac-
tion costs. If you wanted to sell a $5-wide
put vertical for $2, your max risk would be
$300 per spread. Selling four would keep
you under the 5% threshold. To see this in
action for any options strategy, fire up the
Analyze tab on the thinkorswim® platform
from TD Ameritrade (see Figure 1).
When selling naked (uncovered) options,
it’s a little trickier to gauge the risk because
it’s unlimited. But you can set a stop order
at a level that represents your risk limit. So
if you’ve sold five naked put options at $1.50
for a net premium of $750, and you’re not
interested in buying the underlying stock if
Economists measure “marginal utility”
as the amount of benefit derived from the
next dollar. For you trader, it boils down to
one question: As the value of your account
grows, should risk increase proportionately? For example, suppose your account
were to suddenly double in size—say from
$25,000 to $50,000. If your typical risk per
trade is 5%, would your standard unit size
go from $1,250 to $2,500? Should it be more
or less than that?
The utility assessment isn’t just for
individual trades, but also for aggregate
risk. How much of your trading capital
do you deploy at a given time? Does that
percentage change as the account size gets
bigger and smaller? Like many things in
life, it depends.
RIGHT-SIZING YOUR OPTIONS S TRATEGY
For options trades, one guideline you could
start with is the 5% rule. The idea is to limit
your risk per trade to no
more than 5% of your total
portfolio. For a long option
or options spread, it’s pretty
um you pay divided by your
account value. If you’ve got
assigned, you could set an alert below the
strike price. If the stock falls below it, you
would liquidate the short put position. Your
max risk would be the loss per contract
times five contracts, minus the $750 premi-
um you collected.
Likewise, if you’re willing to set stop
orders (and be diligent about sticking to
them), you could also consider increasing
your contract size on any defined-risk
strategy. But with any short position there’s
a risk that assignment can happen at any
time. And a stop order won’t guarantee an
execution at or near the activation price.
Once activated, stop orders compete with
other incoming market orders.
After determining your risk-per-trade
starting point, think about how much of
your available capital should be deployed.
And for that, we return to utility.
UTILI T Y REVISI TED:
TOTAL RISK/TOTAL RE TURN
We all know Uncle Fred, who at the holiday
dinner table freely mixes his entree and
sides. Any inquiry is met with a logically
sound, but equally unpalatable quip:
“It all goes to the same place, kid.”
You could say the same thing about your
portfolio. As a general rule, it makes sense
FIGURE 1: Analyze it. Price an option or spread from the Analyze tab on thinkorswim
and note the dollars at risk. Change the trade quantity until you find your target level.
Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
= $1,200 Change