What you really have at risk in a specific option 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’s risk is limited to the premium or purchase price. However, a short option has theoretically unlimited risk since the market may move up or down infinitely.
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 an option 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 then 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. This is not a complicated calculation, which is the way it should be. The easier it is to stay consistent the more likely it is that you will be able to accomplish your primary trading objectives.
In the video I will look at the process of determining a position size for two option trades trades. In the first example I will evaluate an outright long option position, and in the second example I will walk through a covered call. The second example is slightly more complex becuase it includes a long stock position with a short call combined into a single trade.
The most important principle to take away from this discussion on position sizing is consistency. If you are trading without a set position sizing plan, you will be inconsistent and that will introduce additional volatility into your account, which will create losses. This is one of the most common problems new option traders deal with, but it is also one of the easiest issues to solve.