Traders often begin trading before they are ready. When you can delay trading until you are educated requires great discipline. However, human nature being what it is, and with new traders being especially confident that they will be very good at using options (with no solid reasons why that should be true), traders often get started too soon. Most of them are smart (or afraid) enough to begin with small positions.


The rationale for trading now and learning later is: "let's just see how this works."

If that describes you, and if you are anxious to begin (and if I cannot talk you about of that idea) -- even without any idea about which options to trade -- please take this discussion very seriously.

**When it comes to managing risk for any position -- every step of the way, from initiating the trade until closing the position -- choosing position size is the most important decision, and  the easiest one to make. Is is the basis for manageing risk for the trade. **

Position size is easily defined. It is the number of options (or spreads) bought or sold. Fortunately it is a very easy decision for most traders. Problems in this area occur when traders become overconfident and believe that a given trade 'cannot lose.' That's when they trade too much position size (too many option contracts) and place their trading accounts in jeopardy.

Let's see how this works. For our example I'll pretend that I want to use the strategy of writing naked put options.

If that strategy is unfamiliar, take a look at this description.

Scenario. I'd like to buy 300 shares of XYZ stock. The current price is $41.25 per share and my plan is to buy those shares at $40.00 or less. So, I'm going to sell no more than THREE XYZ puts. For this example, the option expires in 60 days and the premium (option price) is $0.80 (that translates into $80 per option).

• If the options expire worthless, I'll keep the $240 (3 puts @$80 per put), minus any commissions.
• If XYZ is below $40 when expiration arrives, I'll buy those 300 shares at $40 per share. For a description of just how this happens, see the articles on exercise and assignment.
• You now own stock at a net cost of $39.20 per share, $11,760 worth of stock. (You paid $40.00 and can subtract the put premium, or $80 per put.)

 

To measure risk, you must assume that you eventually buy 300 shares and that the stock price could decline by some large percentage. Let's assume 40%. That's a move from $40 to $24.

For this trade to be appropriate from the position sizing perspective, the following must be true:

• You are willing to invest $11,760 into XYZ shares.
• You can afford to invest $11,760 into XYZ shares.
• You can afford to lose 40% of that investment ($4,700).

 

NOTE: I am not suggesting that you would lose that much. Only that it is a possibility that you cannot afford to ignore. Worst-case situations do occur occasionally (think of a Black Swan event) and you want to survive with minimum losses when that happens. The first point of risk management is to recognize how much is at risk and to invest accordingly.

Perhaps XYZ is a solid company in a solid industry. Perhaps it pays dividends. In that case, allowing for a 40% decline is way too conservative. Perhaps you believe that a 20% sell-off is the worst that can happen. If you believe that, then use the 20% number to determine your maximum position size for any trade.

You never have to trade the 'maximum position size.' But if you want to survive and if you plan to trade for many years, then my urgent advice is never to trade more than the maximum.  

Takeaways: Learn first. Trade later.

When you do make a trade, be aware of the worst possible outcome. If the loss from that outcome is more than you are willing (or can afford) to lose, then reduce position size until you are comfortable with the money at risk. There is nothing wrong with trading options in 1-lots. [The term 'lot' describes the number of options in a trade. For example, Joe bought 5-lots of IBM calls.]

This is important because too many traders, and especially inexperienced traders, simply ignore what can go wrong, and think only in terms of how much money they are going to earn.

Part II