Position Risk: the Main Element when Managing Risk

Large and Small Siz. Google Images

Traders often begin trading before they are prepared. It takes discipline to delay trading until you are sufficiently educated. However, with human nature being what it is, and with new traders being especially confident that they will be very good at using options (with no evidence as to why that should be true), traders often get started too soon. The good news is that most of them are smart (or afraid) enough to begin by trading small positions and risking a smallish sum.

The rationale for trading now and learning later is: "let's just see how this works." If that describes you, and if you are anxious to begin (and if I know that I am unlikely to talk you out of that idea) -- even without any idea about which options to trade -- please take the following discussion very seriously.

When it comes to managing risk for any position -- every step of the way, from initiating the trade until closing the position -- choosing an appropriate position size is the most important decision. Fortunately, is the easiest decision to make.

Position size is easily defined. It is the number of options (or spreads) bought or sold. Fortunately choosing the appropriate size is not difficult because it is based primarily on only two factors:

  • What is the worst possible result, and can you afford to place that sum at risk?
  • Is it worthwhile to take this risk when seeking to earn the potential reward?

    Other factors, such as the probability of earning a profit vs. incurring a loss must also be considered. 

    One large problem occurs when any trader is so confident that a specific trade 'cannot lose.' That is when the novice trader, or the overconfident trader, trades too many options and places his/her trading account in jeopardy.

    Sure no one plans to blow up a trading account, but when you buy/sell extra spreads (or single options), based on your belief of a guaranteed profit -- that is when disaster can strike. 

    Let's see how this works with an example. Assume that you want to adopt the strategy of writing naked put options.

    Scenario. you want to buy 300 shares of XYZ stock. The current price is $41.25 per share and the plan is to buy those shares at $40.00 or less. Thus, you sell exactly THREE XYZ puts. For this example, the option expires in 60 days and the premium (option price) is $0.80 (that translates into $80 per option).

    • If the options expire worthless, you keep the $240 (3 puts @$80 per put), minus commissions.
    • If XYZ is below $40 when expiration arrives, you are assigned an exercise notice and buy those 300 shares at $40 per share. For a description of just how this happens, see the articles on exercise and assignment. You now own stock at a net cost of $39.20 per share, $11,760 worth of stock. (You paid $40.00 and can subtract the put premium, or $80 per put.)
    • NOTE: By selling only 3 put options, the most stock you can own from this trade is 300 shares -- and that is the number of shares you were willing to own. It is very tempting to sell many more than 3 puts for the simple reason that you believe the stock price cannot dip below the put strike price. Consider the problem of the person who sells 10 puts, and who finds himself owning 1,000 shares. When the stock price continues to decline, you would face a margin call and be forced to sell those shares. You would never buy 1,000 shares in this scenario, so please, do not sell 10 puts.

      To measure risk, you must assume that you eventually buy 300 shares and that the stock price could decline by some large percentage. Let's assume 40%. That's a move from $40 to $24.

      For this trade to be appropriate from the position sizing perspective, the following must be true:

      • You are willing to invest $11,760 into XYZ shares.
      • You can afford to invest $11,760 in XYZ shares.
      • You can afford to lose 40% of that investment ($4,700).

      NOTE: I am not suggesting that you would lose that much. Only that it is a possibility that you cannot afford to ignore. Worst-case situations do occur occasionally (think of a Black Swan event) and you want to survive with acceptable losses when that happens. The first point of is to recognize how much is at risk and to invest accordingly.

      Perhaps XYZ is a solid company in a solid industry.

      Perhaps it pays dividends. In that case, allowing for a 40% decline is way too conservative. Perhaps you believe that a 20% sell-off is the worst that can happen. If you believe that, then use the 20% number to determine your maximum position size for the trade.

      You never have to trade the 'maximum position size.' But if you want to survive and if you plan to trade for many years, then my urgent advice is never to open a position that could trade lose more money than you can afford. This is not something that a novice trader takes into consideration. 

      Takeaways: Learn first. Trade later.

      When you do make a trade, be aware of the worst possible outcome. There is nothing wrong with trading options in 1-lots. [The term 'lot' describes the number of options in a trade. For example, Joe bought 5-lots of IBM calls.]

      This is important because you cannot simply ignore what can go wrong, and expect to remain in business.