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.