Trading Options vs. Stock: Position Size is What Really Matters

by: David Andrew Taylor

I had a very tough time pulling myself away from what is surely going to be a special day by Floyd Landis, erasing a mistake from yesterday. But, I missed working altogether yesterday, and need to catch up.

I saw a comment on a post that I wrote. I was surprised to find that I was labeled irresponsible in the comment for the mere mention of trading options. Really? That sounds a bit naive to me. Here's the exact comment:

Just mentioning involvement in options to a broad audience as you have done is irresponsible. There is so much to know and great risk which you never mentioned.

In fact, there is a great deal of risk in trading in general, regardless of the market or method of trading. Period. I thought that was a tough generalization to say that mentioning options specifically on such a broad scale was irresponsible. I try to imagine that my audience is somewhat sophisticated... although, I am well aware that there is more than one "new trader" that stops by my site. Regardless, I don't see options as taboo. Instead, I think all new traders should consider embracing them.

[May I also insert a link to my now "world famous" disclaimer for all to enjoy. Apparently, this has been cut out and emailed all over the trading world as to the proper way of writing a disclaimer.]

The timing of this comment couldn't have been better. A very good friend of mine out in Los Angeles is embarking on a trading career in the hopes of making a living. We've had countless discussions as to trading theory and mechanics. So much so that, if he were to walk into my office and see the trade board, he'd be able to give a detailed explanation to a complete stranger as to what my thinking was when I put on the trade, and what the goals of such trade were. My trades are generally always the same, so that's easy.

He asked for a bit of sage advice from someone that has been successful in the business for over 11 years. My advice: Make sure you can sleep at night. This advice has nothing to do with trading a 24-hour market. On the contrary, I trade 24-hour markets solely so that I have the opportunity to trade any time I want. I'm serious when I say this: I hate weekends. The markets are closed. Instead, this advice acts as a method of managing positions and what goes on with them.

Let me tell you one specific strategy about options trading that I employ all the time. Synthetic long/short. I actually put together a write-up on this explaining in detail what the position is.

One of the things about synthetic positions that I like is that if I'm wrong about the market, I've typically built into the position a cushion that allows me to be "wrong" for a period, without officially being wrong. Herein lies the secret to my success of what I've been able to do.

Now, before anyone out there starts screaming bloody murder about a complete disregard to the legendary notion with being short options that "those things can grow wings", let me point out another thing that can grow wings.... ANY losing position. The detailed explanation about the options strategy from above focused on a trade that I had on, a short 1350 call, long 1250 put. My hope was that the 1350 call would expire worthless, as the 1250 put would have gained in value. The S&P 500's level at the time was about 1310. After I put on the position, the market moved higher by 16 points, only to fall down what is now about 70 points. I know some traders would have put in a stop somewhere above their entry. This may have caused an individual to get out of the market because of a changed outlook. You would have missed a great move.

One thing that the commenter failed to take into account is that regardless of the type of position being put on, size does matter. Although I may get a little cavalier at times with my own personal account, I don't have that option with my customer accounts, or the fund. Size is always a major concern when I trade.

Let's look at an example... and I'm pulling numbers out of a hat. Your own specific size ratio is yours, not mine.

If you had a $100k account, and put on either the short outright position or the short options position, your account may have looked like this:

a. Short outright position from 1310 would have been a negative 16 points at $250 a point for a total of: -$4,000.00 or 4% of the account size.

b. Short 1350 call, long 1250 put: Call options appreciated a whopping 3 points and the long puts depreciated about the same for a total of -6 points, or -$1,500 for a total of -1.5%.

How is that irresponsible?

Your size ratio is going to be what it is. If you put on too many options, then you're asking for a decimated account size. If you put on too many positions in the outright market, your asking for a decimated account size in a shorter period of time. Your call.

Sleeping at night is a trading philosophy that I try and embrace ever day when I pull the trigger. I think if you ask yourself that one single question right before you put on the trade, you're on the right track regardless of the type of position you put on.