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Position Sizing with Stock Options

Risk management and position sizing are the two most important things to consider when incorporating options into a portfolio. We're going to go through the steps on how to make a better decision when taking on a position using stock options.

The first thing to consider is how much you are willing to risk (lose) in a specific position. For this example, a $100,000 portfolio will be used to help keep the numbers simple.

Let's assume that you want to risk no more than 1% of your portfolio on a trade.

100,000 * .01 = $1000 risk

Options are a good financial instrument when you wish to limit your loss. When taking a loss on options you can either let the contract expire and lose the full premium that you paid, or you can sell it at market price. Let's look at two examples. Note that they are not specific trade recommendations and probably would not make money, and are for educational purposes only.

First an index play. Currently looking at DIA Oct 106 Calls which are trading at 4.50. Since these options are out of the money, the entire value is extrinsic (premium). So if nothing happened and it expired tomorow, then the contract would be worth nothing. So let's assume that you are willing to risk all premium and want to establish a position.

1000 risk / 450 premium = 2.2 contracts

So this means that with your current risk tolerance you would only be able to buy two contracts.

Let's take that example and instead of accepting all the premium as risk, a stop is placed 2 points away from the current price. Since you are trading a derivative of the price, you will have to calculate the loss of the option. There are two ways to do that. First, you can look at the delta of the option (.52) and look at where your stop is:

.52 delta * 2 point stop = $104 risk per contract

$1000 absolute risk / $104 risk per contract = 9 contracts

The second way to do this is only if you have the thinkorswim platform. Simply simulate the trade and move the price slice to your stop point. This accounts for other variables besides delta such as gamma and vega. (To learn more about option greeks, click here).

With the analyze tab, you can see that your risk tolerance is 10 contracts. You can see how you can use options to establish significant leverage in your portfolio. To learn more about leveraging with stock options, click here.

Do note that this takes into account only directional risk, not volatility risk. Buying puts and calls is positive vega, so any drop in volatility will cause the value of the option to go down.

Adjust Your Portfolio Using Stock Options

One of the best advantages with adding options to a portfolio is the ability to hedge systemic as well as positional risk. This gives you the ability to add diversification, reduce risk, and sleep better at night.

So I went ahead and designed a "poor people" portfolio. Here's the rundown:

MCD: I eat there all the time. (200 shares @ 62.93)

KO: I need something to drink with my Big Mac (1 May 09 55 Call @ 4.40)

WMT: They have both! (500 @ 60.75)

PSA: I need a place to put all the stuff I bought at WMT (100 @ 90)

COH: I never shop there so they're going bankrupt (2 Jan 09 22.5 puts)

Here's what the portfolio risk looks like indexed against the SPY:

Poor People Portfolio

Poor People Portfolio

You can see that after weighting it against a broad based index, your portfolio is the equivalent of holding about 192 shares of SPY. This is your systemic risk. Of course the reason you bought these positions is because you believe that they will outperform the market over time, but you'd like to reduce your overall market risk. So what can you do?

Sell OTM call verticals. We'll go 2 months out and sell some calls that have about 30% probability of expiring in the money. The Nov 08 119/121 Vert Call Spread is selling right now for .70. Take on 10 verticals (20 total positions) and your risk goes from 192 to 143 a 25% decline from the beginning. On top of that, you're adding on an extra $700 in potential return provided the market stays below 119. You can do a lot better when you time it a little more and sell during a run-up than during a run-down. Here's the new risk profile:



Also, it would make more sense to not establish a full on position but rather put it on gradually. Also, that extra $700 dollars gives you a return:

700 / (111.85 [spy close] * 143.32 [portfolio delta] ) = 4.3%

That means your systemic basis is reduced by 4%. Hope this shows how options can be very powerful as a hedge as well as generating a little extra alpha.

How to Invest in a Company Using Naked Puts

Become a better investor using stock options

So you've done all your due diligence and analysis and you've found a public company that you would like to invest in. If you're like most of the retail traders out there, you simply go out and start buying stock out on the market at an acceptable price level.

But if you're going to do that, why don't you pick up some premium?

We're going to discuss one of the best techniques for an investor to acquire the shares of a company: Naked Puts

What this means is that you acquire stock by writing a put. This leaves you "naked," which means that you are under obligation to come up with the money to buy 100 shares of stock at a certain price. But that's what you wanted to do in the first place, right?

The first concern that you may have is that this strategy is known as "risky." But let's see what that actually means. Generally, if you sell a front month ATM (at-the-money) put, your delta exposure is around .40-.50. That means for every point move in the underlying stock, your contract value changes by $40-50. If you were planning to buy 100 shares of the stock in the first place, your delta exposure is half if you were in a naked put position. This means that your risk is cut in half, so if the stock goes against you, it does so with half the consequences.

But the real reason you write a put is the premium that you collect that will reduce your basis in the stock. With a month left, you can collect 3-5% return on basis for index funds, and 4-7% return on single stocks. This gives you a tremendous advantage in the long run.

Let's look at a real world example. This example was taken on Sept 29, 2008. It is an AAPL option chain.

AAPL Option Chain

AAPL Option Chain

This was taken after market and during a significant drop in price. This is used as an example only and by no means is a trade recommendation. This particular example is interesting because it comes in a time of extreme market volatility. We're assuming that the hypothetical investor thinks that acquiring AAPL at $100 a share is a good idea. Instead of going outright and acquiring the stock, he can sell a front month 100 put for about 8.20. Let's see what kind of return that gives us.

$100 Collateral needed - 8.20 premium = 91.8 basis

8.20 Maximum gain / 91.8 basis = 8.9% return

This gives us 8.9% return on basis in 18 days. That's a significant edge, especially if you think buying AAPL at 100 a share is a good idea.

Here is what the risk profile looks like:

Risk Profile of AAPL

Risk Profile of AAPL

Managing this position can become very interesting. Ideally, this position is slightly bullish. You aren't expecting a large move. But if a large move happens to the upside, the put loses value and the investor can choose to either roll to a new strike to maximize their premium potential, or they can take the gain off the table and eliminate risk completely. You could even try and reenter the position at a more favorable price.

If the position moves to the downside, that is acceptable to the investor because he or she was comfortable enough to buy shares at that price anyways. If the put is exercised against them, they buy at that strike and then they can comfortably move to a covered call or a stock collar (strategies discussed in a different post).

This example can be replicated with any security that has options available for it. If you do plan on getting long stock, you should definitely have this strategy in your arsenal.

We hope that this tutorial helps you to become a better investor and trader. If you'd like to gain even more of an edge, you can become an IWO member. Receive videos filled with trading ideas and market commentary. Click here to become a member!

Deep In the Money Stock Option Strategies

Most option strategies that market players incorporate into their trading plans involve option contracts whose strike price is close to the trading price of the underlying. People use these contracts to magnify gains and leverage their assets.

But there may be times when you want to get long stock as much as possible without worrying about time decay. By using deep in the money stock options, you can emulate stock movements with less capital at risk. Take a look this option chain of Google (GOOG):

GOOG Option Chain Oct 08

GOOG Option Chain Oct 08

We've broadened out the strike prices so you can see all the options available. The two values listed are delta (the change in the option price versus the change in the underlying) and extrinsic (premium left on the option). You can see that as options get further in the money, the delta increases and the intrinsic decreases. If you get in far enough, you can use a deep in the money option to substitue for stock.

Take the Oct 250 cals. There is only 1.30 of premium left on the option, or 1% of the overall option's value. The since there is almost all intrinsic value, it will mirror the movement of the stock. The 250's have .97 delta, which means it will move $97 for every 1$ move in the stock. This is the equivalent of owning 97 shares.

The upside to this is that you can use this to leverage your assets. If you were to buy 100 shares of google in a non-margined account, you would need $39,000 available. That's a tremendous amount of capital to tie up in one trade. But to get nearly the same amount of exposure, you can buy that 250 call for a cost of 14,170. You can calculate the total leverage like this:

38220 (98 delta at stock cost) / 14170

2.70x leverage

So you are essentially gaining exposure in GOOG without putting up all the necessary capital.

There are downsides to this. The options market does not have tight spreads compared to the trading in the underlying, so there would be some slippage. And gaining that sort of leverage can be dangerous if you don't know what you're doing. But if you wanted that sort of exposure in the first place without tying up all of your capital, then deep in the money option strategies are a valuable tool.