Today I want to talk about how to determine the correct position
size for options.
There are actually several different ways, but I have found the
ones below to be the most useful. Plus, it's what I do in my own
As you know, you can get started in options with only a fraction of
the amount of money you would normally need to invest in the stock
But if you put in too little, it will hardly make a difference in
your account if you're right. Put in too much and it'll put a big
dent in your account if you're wrong.
How Much Should You Invest in Each Option?
Determining the right position size is critical for successful
investing. Here's how you can determine the right position size for
For example: Let's say you would normally invest $10,000 in a
stock. If stock XYZ was trading at $50 per share, that means you
could buy 200 shares. And let's also say you were willing to risk
10% on the trade or $1,000.
Here's how to figure out your option size. One option essentially
equals 100 shares. Two options equal 200 shares. If you buy one
option at $500, under the worst case scenario, your maximum risk
would be what you paid for the option or $500. Two options would be
$1,000. And that's the equivalent of risking 10% had you invested
$10,000 in the stock.
Of course, that's assuming the worst case scenario. Nobody intends
to lose their entire premium. But it's a good idea to keep the
worst case scenario in mind when determining your position size as
this is a foolproof way to manage your risk.
Sometimes you may need to buy a few different strikes to stay
within that dollar amount. Instead of buying two $45 calls, maybe
you buy one $45 and one $47.50 call.
Of course, there will be times when you find yourself 'needing' to
spend a little more on quality options. That's OK, as long as you
have plenty of time.
In other words, if the stock collapses for whatever reason, your
option will take a drubbing. But, if there's lots of time on it, it
will not go to zero overnight. So as long as you're disciplined
enough to pull the plug at a specified dollar loss, then you can
still keep your losses to your preferred worst case scenario
For example, if you purchased two great options for $700 each, that
means your total cost/investment is $1,400. If those options ever
lose a combined total of $1,000 (loss of -$500 on each), you'd sell
them. And by doing this you're account would never get into
It takes discipline. But discipline is probably the most important
skill in options trading. And if you can manage your downside, the
profits will take care of themselves.
Put this method into practice on your next option purchase for a
You can learn more about different types of option strategies by
downloading our free options booklet: 3 Smart Ways to Make Money
with Options (Two of Which You Probably Never Heard About).
Just click here.
Disclosure: Officers, directors and/or employees of Zacks
Investment Research may own or have sold short securities and/or
hold long and/or short positions in options that are mentioned in
this material. An affiliated investment advisory firm may own or
have sold short securities and/or hold long and/or short positions
in options that are mentioned in this material.
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