Position Size 2.

How Much Can I Afford to Lose?

Position Size
Choose an appropriate position size. pixabay.com

The importance of trading appropriate position size has been discussed. This time let's look at this essential risk-management tool from a different perspective. 

If you have a trading account with $5,000 devoted to option trading. There are a number of good methods for deciding how much risk you can afford to take per trade. For example,you may want to adopt two or three different strategies and allocate one-half or one-third of available cash to each strategy.

A commonly used alternative is to risk no more than a specific sum (perhaps $200) for any single trade. It will probably take a few trades before experience allows you discover where to set your limit, but when making your very first trades, the important factor is knowing that there has to be an intelligent method for deciding how many options, or option spreads, to trade.

NOTE: Risking 10% of the total account value on one trade is a VERY high percentage. I recommend risking no more than 5%, or $250 in this example. However, the final choice depends on you and how comfortable you are with each specific trade.

NOTE to short-term stock traders: It is common practice to risk no more than 2% of your entire portfolio on any given trade.  Setting a stop-loss price allows you to exit gracefully when a trade is not working as expected.

However, please remember that options are not stocks and it is impossible to trade spreads (hedged option positions) with very tight stop-loss points:  is too high, commissions add up, and the bid-ask markets can change suddenly for no obvious reason. A stop-loss order may result in the sale of a perfectly good position.* There is no efficient method for exiting with a tiny loss as you can when trading stocks.

Option spreads are designed for longer holding periods - from a few days to a few months. We do close some of our positions as a normal part of risk management, However, exiting a spread is an inefficient process and thus, setting a tight stop loss will cause too many early exits.

*When calculating the value of a position, the price of each individual option is considered. if one of those bid/ask spreads shifts momentarily, the value of the spread changes, and that may trigger your tight stop-loss order. I urge you not to use stop-loss orders for an option spread.

Recognizing high risk when you see it

When you own $10,000 worth of stock, you know that it is possible, although extremely unlikely, to lose the entire $10,000. Thus, it is difficult to gauge just how much cash is at risk. True, you can use a limit stop-loss order and >99% of the time, you should be able to get out of the position (as the stock price falls) very near, that stop-loss price.

Every once in a while unexpected bad news appears, causing the stock price to gap and open below the limit price. Under these conditions -- assuming that the order is a stop loss market order and not a stop loss limit order -- the loss will be larger than anticipated, but remains unknowable in advance. 

It is much more common for an option position to result in a total loss. In fact, traders who buy individual options often see those options expire worthless. The crucial point is that you cannot invest that same $10,000 into an option position with the belief that you have a similar risk as when owning an equal dollar amount of stock. Sure, there is a maximum possible loss of $10,000 with either position, but the probability of losing the entire sum is always much larger with the options trade because stocks seldom move to zero.

Bottom line: Option trades must always understand just how much money can be lost before making any trade. Unexpected events do occur, and the successful trader understands the stakes. Don't forget about potential gains. When you know how much you can earn (because the trade has a limited profit or you plan to exit when the profit reaches a specific level) -- and how much you can lose -- that makes it easier to decide whether making the trade will leave you within your comfort zone.