Option Traders: Increase Profit Potential Without Adding Undue Risk

 |  Includes: SPY
by: Greg Loehr

I once spoke with an options trading student who said he was 80% right on his stock picks, but was still losing money. How could that be? He readily admitted that after four straight winning trades he got greedy and risked far more on his fifth trade than he had on the previous ones.

Shocker - the fifth trade lost. It lost in an amount that wiped out the profits from the previous four trades. Don't quote me on these numbers, but it was something like four straight $2,000 wins, and then one $10,000 loss.

You're destined to lose on that one over-sized trade. Blame it on Murphy's Law.

Protecting against this problem comes down to one thing: proper position sizing. The amount of money at risk in your option trade shouldn't be defined by the number of contracts you trade, but rather by the percentage of your trading capital at risk in the trade so that trades are equally dollar-weighted.

So here are some guidelines that can help you avoid the inevitable losing trades from overwhelming the winners.

First, you have to define what you're using for your trading capital. This probably shouldn't be the money you're counting on to pay the mortgage or put food on the table. You should never risk money that you can't afford to lose; doing so only puts undue pressure on you and that will really mess with your mind. So as an example assume a trading portfolio of $10,000.

Second, risk no more than 5% of your portfolio on the option trade you like. In this example 5% of the $10,000 account equals $500. If you want to buy a call option that costs $1.00, then you'd buy 5 contracts to equal $500 of "theoretical" risk (I discuss "real" risk below). If you want to buy a put spread trading for $0.50, then you would buy ten spreads. The number of contracts you trade are determined by the amount of risk in the trade that equals 5%.

What if I sell a spread instead of buying it? Same thing: determine the risk in the trade and then sell the appropriate number of spreads. For instance, if you sell a $2-wide put spread on the S&P SPDR ETF (NYSEARCA:SPY) for a 35-cent credit. Your risk is $165 per spread, so selling three spreads would equal $495 of risk. Not exactly $500, but close enough for government work.

Credit spread traders, please keep this in mind: selling a spread reduces your option buying power (the money you can trade) by the amount of the risk - just like a debit spread. So it's really a "credit" in name only.

Remember, these are guidelines. Perhaps you're comfortable only risking 4% of your portfolio. Fine. Just keep every trade you enter as close to that number as possible, and the 5% (or whatever you choose) is taken from the net liquidating value of your account, not from the available cash.

Third, part and parcel of this "5% rule" is the necessary proper trade management that limits the losses of the trade, yet allows for profits to be made. Cutting your losses when your trade hits a 50% loss, and taking profits when the trade makes a 100% profit, makes for a decent guideline, but trade plans can be as varied as the trader. The idea is that your trade management should adhere to the timeless saying of "cutting your losses and letting your winners run."

The above rules have been based on the "theoretical" risk in the trade - the maximum risk. In reality you should never let a trade get to its maximum loss. But if it should occur, say, if a stock gaps wildly against you, then at least the contained risk of 5% won't handicap your account.

Assigning a risk of 5% to each option trade and managing it as discussed here works best when your trades are similar. For example, a trader may only buy calls or puts with two months to expiration to match his/her technical analysis for a stock. Or a trader may do nothing but sell shorter-term spreads or iron condors as a higher probability approach.

When option trades start to become dissimilar, however, the framework of 5% at work in the trade, and a trade plan of 50% loss, 100% gain, may no longer be appropriate.

Here's an example assuming you're bullish on a stock. A call option with one week till expiration is going to react much differently than buying a LEAP call with two years until expiration. The shorter term option is going to change in value incredibly fast compared to the LEAP. That could be good or bad, right?

Short term options will decay very quickly, and since you may not have much of a chance to cut the losses on such a trade if it goes awry you might consider only risking 1% perhaps. On the bright side of this trade, the heavy theta also means the option has a lot of gamma and could produce immense profits very quickly if you're right. So that can make up for only having 1% of your portfolio at work.

Another exception to the 5% rule could be when buying a straddle (or a strangle). As a quick aside, straddles should only be bought if the implied volatility is in the low end of its range. The idea behind risking only 5% per trade is to keep your account from getting slaughtered if the trade moves against you.

With a straddle (again, assuming volatility is very low), it's going to be really hard to lose a lot of money right off the bat. You'd have to incur a big volatility crush or a lot of time decay before getting to the loss exit on a straddle. Perhaps risking 10% on the trade isn't as risky as it might sound.1 If the implied volatility is very low and doesn't move lower, then the only problem would be time decay which can eventually be avoided by closing the trade.

Finally I'll close with one other example. Assume the following trade:

  • 7% potential profit in one week for the trade
  • approximate 84% of making that 7% profit or more based on the option model
  • an outside chance of as much as 115% profit in one week
  • can withstand an overnight two standard deviation move (for the SPX that would be approximately 30 points as of this writing) in the underlying before hitting a 20% loss

Would you be willing to risk more of your portfolio on this kind of trade?

There are money managers who do, putting upwards of 10, 20 or 30% of the portfolio into one position. Obviously this sounds risky, and it would be for an option trader to do this without understanding every facet and nuance of the trade.

The strategy I'm referencing is a variation on the typical butterfly. These trades are opened for a credit and can perform similarly to a typical credit spread. But there are also key benefits that credit spreads can't provide. The first one is the ability to lock in the credit prior to expiration. The second benefit is the ability withstand a fair amount of adverse market movement before hitting the point where the trade needs to be closed or adjusted to avoid an excessive loss.

This is where "real" risk is distinguished from "theoretical" risk.
If a trade can realistically survive a two or three standard deviation move before getting out of hand, then it might be OK to risk more of your portfolio.

On November 1, 2012 I demonstrated this type of trade on the Standard & Poor's 500 Index (SPX), selecting and managing the hypothetical trade in a live market (representing 30% of a portfolio) through expiration a week later. By expiration on November 9 the trade produced a 112% profit, which represented a 34% portfolio profit.

Of course this kind of huge portfolio return is a once-in-a-blue-moon event. But with a high probability trade, with the built-in "safety" of a trade that can realistically weather adverse market movements, one is afforded the chance to put more capital to work. Also, without adding undue risk to the portfolio, proper position sizing can still give you the chance to hit it big.

In the end it's the trader's responsibility to only risk what he/she is comfortable with. Taking into account one's experience, and combining that with proper position sizing, hopefully one can avoid more of the needless losses without detracting from your profit potential.

1. One other risk occurs if the company is taken over with a price near the strike of the straddle. In that case volatility would likely approach zero and the straddle would likely get annihilated.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.