What you really have at risk in a specific trade is often a function of whether you are long or short, and how quickly you think you can get out of a bad trade.
For example, a long option has a fixed risk of the premium or purchase price. However, a short option has theoretically unlimited risk since the market may move up or down infinitely.
[VIDEO] How Much Should You Risk in the Options Market
That means that your maximum loss may be just the option premium in the case of a long option, or your stop loss in the case of a short option or long stock position. Once you know what your maximum risk is, you can determine your position’s size.
You can determine the size of a position by dividing that maximum risk amount into the total amount of your portfolio you have set aside for a trade.
For example, if you assume that you are willing to use $10,000 of your portfolio for options trades and you are willing to risk 5% of that amount on any single trade, you are willing to lose $500 in a bad trade. Therefore, if you are evaluating a long call or put position with a max loss of $250 per contract, you could buy two contracts.
Quite often the amount you are willing to risk will vary based on market conditions. It is appropriate to limit the amount you are willing to risk per trade when the VIX or S&P volatility index is high while taking on more risk per position when the VIX is low. In the video you will learn how your maximum loss dictates the size of your position. This is good because it helps you establish consistency in your trading.