In last month’s article, we finished up on why we would want to take the time, effort, and money learning how to trade options. From here, one of the first and most important questions an option trader or investor is going to ask which is how much money should be spent in an option position versus a stock position.
When trying to decide how much money to invest in options, one MUST take into consideration the amount of leverage you get from options. Now, before getting panicked over the word “leverage,” understand that the type of leverage you receive from options is good leverage……that is to say mathematical leverage. It is not the leverage received from borrowing money! That is the type of leverage that got this market in a lot of trouble in 2008 and 2009 in the Financial Crisis.
With that said, options would allow you to do one of two things. You can get a much bigger position with the same amount of money or you can get the same sized position with much LESS money! Obviously, your broker and Wall Street would like you to employ definition number one…..same money and bigger position.
However, it is definition number two which is the one we want. By using less money to have the same sized position, we enacted a solid risk management plan from the get go.
Conventional Risk Calculation
The conventional way to do this (called the Conventional Risk Calculation) is to simply buy the amount of contracts that represents the amount of shares you would buy or sell.
For instance, if you thought a stock was going to go up and you decided to buy some calls, you should first think about how many shares of stock you were going to buy. If you would have bought 500 shares, then you would buy 5 calls.
If you would have bought 1000 shares, then you would buy 10 calls. This is because each contract is worth 100 shares of stock. The formula would simply be to take the amount of shares you would have normally purchased and divide it by 100.
Although a good way control the SIZE of your position the Conventional Calculation does not necessarily balance your risk in the position. That is where a different calculation can be more applicable. This calculation is a risk based calculation as opposed to the position size based manner that the Conventional Calculation does. It is called Ron’s Risk Calculation or RRC.
Ron’s Risk Calculation or RRC
RRC is calculated in a different way with a different concept in mind…….not size but RISK! The calculation is actually pretty easy. First, figure out at what price you would purchase the stock. Then, figure out where you would naturally set your stop. This would create a total amount of dollar loss per share that you would accept. Then, times that by the amount of shares you would have purchased. This will give you a total net amount of money that you would be willing to risk.
For example, say you were going to buy ABC stock at $100 per share. Once purchased, you set a stop order of $90. This basically says that you are willing to lose $10 per share but no more in trying to take advantage of this potential opportunity. Now, if you would have bought 1000 shares and you are willing to risk $10 per share then you are willing to lose $10,000 but no more. That $10,000 is the amount of money that you should spend on buying your options.
The beautiful thing about the RRC is the risk management factor. If you bought the stock and put in a stop order, there is NO guarantee that you would only lose $10,000 maximum. As we all know, stop orders do not work when the stop gaps against you! You could still possibly lose much more! However, if you use the $10,000 (the amount you were originally willing to lose based on stock price, stop price, and total shares to buy) to buy the calls then you can lose only that $10,000 and not a penny more no matter what happens to the stock! Now that right there is a solid start to any risk management program!
RRC works extremely well in shorter term trades due to the much smaller amount of money used in the investment and the much higher option prices out over time. I would not use it in any trade beyond about 2 months out.
However, it is amazingly effective and offers incredible flexibility allowing traders a gigantic advantage in short term trading over the conventional risk calculation.
Join me next month as I discuss more about RRC including the advantages of using RRC, a demonstration of those advantages, and a comparison of the performance of RRC versus a stock position with a stop order.
Until next time,
Ron Ianieri is owner of Ion Options a company he started in 2010. He is also lead instructor at Options Monster Education and editor of the highly successful newsletter “The Income Strategist”. Ron has been trading options for more than 27 years and is also the author of the book “Options Theory and Trading” published by John Wiley and Sons. Currently Ron travels the world teaching investors the same successful Options class he developed during his years on the trading floor.