The old investing mantra don’t put your eggs in one basket couldn’t be more true when it comes to options trading. Options are versatile building blocks for constructing strategies to take advantage of just about every market condition imaginable: ups, downs, sideways, expanding or contracting implied volatility, the passage of time, you name it. Options, however, are also highly leveraged and every option expires.
To avoid blowing up your trading account, you must adhere to proper risk management techniques: selecting trades with high probabilities of success, sticking to defined-risk strategies, using liquid options with reasonable bid-ask spreads, being on the right side of implied volatility and time decay, using stop losses, and of course the focus of this article: proper position sizing.
Why is position sizing so important when trading options?
No matter how good an option trader is, there will always be losing trades. If one trade is given too hefty of an allocation in the overall portfolio and happens to be a loss, a trader can quickly lose a big chunk of their capital.
Here’s an illustration of why keeping drawdowns small is so important. Imagine two portfolios starting at $10,000, both making equal wins and losses from one period to the next. At the same time, one portfolio experiences a -10% drawdown and the other a -30% drawdown. The yellow portfolio obviously takes longer to recover, but the relationship between drawdown and recovery time isn’t linear. The yellow drawdown is 3x as large as the purple drawdown, yet it actually takes approximately 3.37x longer to recover. The bigger the drawdown, the greater the disparity grows to be.
How big should option position sizes be?
It depends heavily on what option strategy is being used. As a general rule of thumb, strategies with a higher probability of success should receive larger allocations, while those with a lower probability should be given less.
Note that ‘higher probability’ trades like iron condors and vertical spreads typically come with the caveat where the maximum potential loss is greater than the maximum potential gain. For this reason, I also consider stop losses based on the premium collected to be especially important for these types of trades. Remember position sizing is only one of many risk management pillars. Everything in the options world is a tradeoff, and it’s all about finding some kind of balance where the strategy mix aligns well with your risk tolerance.
Trades that receive the smallest allocation sizes should be those that require a big move in the underlying to work such as long straddles or debit vertical spreads, since these generally require the trader to be correct on a directional movement.
There is no hard and fast rule as to how big your positions should be, it depends on your portfolio’s overall strategy, the option strategy at play and the underlying. As a rough guideline though, I generally use 15% for the highest probability trades assuming there are other risk controls like stop losses in place, and then as low as 1% to 5% for lower probabilities.
How do you calculate the right option position size?
Once you’ve determined what the allocation size should be for a given trade, calculating the position size, or number of contracts, just takes some very simple and intuitive math:
Maximum Risk per Contract
Where Allocation Size = Total Capital * % Allocation
The maximum potential loss, or risk on a debit trade is simply the debit paid to open the trade. On any option trades routed for a credit, you’ll need to check the maximum potential loss displayed by your trading software. Keep in mind, the allocation size formula above applies to credit trades with defined risk. I don’t trade undefined risk options, so sizing the position is always easy since I know what the maximum theoretical loss will be even in the worth case scenario.
The short iron condor is considered defined risk because purchasing two further out-of-the-money long options cap the maximum loss. It’s undefined risk cousin is a short strangle – the same trade except without the long options.
Let’s use an iron condor we traded in the Tactile Options Mini Portfolio as an example. Here is the snapshot for the trade in Trader Workstation by Interactive Brokers, when the daily email went out to subscribers on December 22, 2021:
This trade was routed for a credit, so the number we’re sizing the position based off here is the Max Loss in the red box.
Even though I always trade my iron condors with a stop loss based on the premium collected, in this case 183, it’s still best practice to always scale the trade based on the maximum loss. This will ensure you are not over-allocated.
Using the formula above, let’s assume somebody wanted to trade this iron condor with $10,000 of capital. Let’s also assume they chose a 15% allocation size. Since they also use stop losses, sell contracts that expire further out in time to avoid gamma, and wait until implied volatility is very high, this trade is fairly safe and has a reasonably high probability of success so a larger allocation size is appropriate.
Allocation size = $10,000 * 15% = $1,500 in total risk
Max Risk per Contract = $817 from the trading software
Position Size = $1,500 / $817 = 1.83
The trader would round up and sell 2 contracts, or round down and only sell 1 depending on their risk tolerance.
This simple formula applies to all option trades, debit or credit. It even applies to trading The Wheel: cash-secured puts and covered calls. When selling cash-secured puts, use the total reserved cash (short put strike * 100 shares) as the maximum loss to correctly size the position. Always trade to trade another day, and keep those position sizes reasonable!