The Options Speed Limit

Congrats! You’ve just graduated from the school of options. You know everything there is to know about calls, puts, spreads, strangles, condors, etc., and you’re ready to make your first trade. The order ticket is filled out and you’re good to go except for one question… How many contracts should I trade?

There are countless methods out there about how to position size when it comes to stocks (with several large books dedicated exclusively to the subject), but hardly any have a definitive method for applying position sizing to options.

That is, until now.

The Options Positions Sizer (which is now available for download) takes all the guesswork out of what can often be a daunting task. There are some folks that say, well it’s really easy… you just simply take a certain percentage of your account for each position. Problem solved!

But anyone out there with a halfway decent options school degree knows how things like volatility and time can drastically affect the options premium. And depending on these factors when you enter the trade, a percentage position can go a very little or not such a very long way.

The Options Position Sizer delivers a percentage amount, but things like volatility, leverage and the stats of your own system are automatically factored in. The result is just the right amount of contracts to trade.

Think of options trading like driving a car, and the amount of contracts is how fast you can drive. You may be able to get up to a considerable speed, but given the risk inherent in options (where a 100% loss is possible), it’s a good idea to know how to use the brake. And driving too slow also has its dangers as well.

So what speed is just right? Some symbols may vary, but for SPY options it’s somewhere between 5 and 15% of total account capital for each position. Let’s go through a potential trade with our own TVO System and the Options Positions Sizer to see how it works.

1. If position size is the speed limit, then theta or days left to expiration (DTE) is the amount of gas in the tank. You want make sure you’re not left holding calls (if you’re selling calls that’s another story) while theta starts to burn.

The premium starts to rapidly decay about 30 days before op-ex, so determine the maximum length you need for your trading strategy to play out, and then add 30 days on top of that. So for example if you need a month for the trade, choose an expiration date that’s at least 60 days from now.

2. Next up is the previous days underlying price of SPY and the implied volatility (IV) calls average. These fields can eventually be changed on the fly closer to the trade, but having this data automatically updated gives us a head start.

Underlying price, IV, DTE, along with dividend yield and the interest rate (all downloaded automatically) are used to calculate the options price. This is done with a Black-Scholes calculator, which is conveniently built right in.

3. The total capital is the value of all open positions plus cash in your account.

4. If theta is the gas in the tank then delta is the oil gauge. Being low on oil wears down the engine and low delta has a similar effect on both your premium and the chances of a profitable trade. Too much oil is, well, just unnecessary, and a higher delta adds considerably to the premium and weighs down price action, making the option behave more like a stock.

For some this seems like a path to less risk, but high delta can diminish leverage which, as we’ll see, is one of the real advantages of options over stocks in the first place.

5. What kind of car are you driving? Here’s where you fill in the statistics of your system. The TVO System stats are available from the dropdown menu. Later we’ll see how this applies to the end result.

6. The strike price is the underlying price rounded to the nearest dollar. This gives us close to a .50 delta, which is considered to be at-the-money (ATM) and just the right amount of oil to get the most mileage out of theta and volatility.

Now that we have the options price and the number of contracts, let’s see what’s going on under the hood.

7. The Kelly Criterion, or fortune’s formula, is an equation used in gambling for determining bet size. The only problem, however, is that when applied to trading, the “bet size” is often way too large for any sensible amount of risk, especially when trading several positions at once.

As a result, the Kelly percentage is often modified. In this example the recommend 47.78% (almost half of account capital!) has been reduced to a more manageable 6.91%.

8. But wait, there’s more. While we could stop there, this is where leverage or lambda comes in. Dividing the options price by the delta times the strike, we get how much leverage our options have over the underlying asset. In this case it’s 27 times. We would have to spend 27 times more than the options price for one call to get the same kind of price movement as the ETF (about 50 shares of SPY).

Taking the modified Kelly divided by the lambda times our system stats tells us, in this case, we can allocate as much as 14.08% of capital to the position size.

9. The cost of options is the number of contracts times the options price, but the position size field is the exact quotient of the formula. This is then rounded to the nearest contracts. You can’t trade 7.93 options contracts, but it helps to see if we’re close to one or the other, especially as we get closer to the speed limit.

If the position size percentage goes over the limit, you always can reduce the number of contracts.

So what exactly is the speed limit? This can vary depending on how many positions or systems you use, but generally you may want to limit your position size to no more than 10-15% of total account capital. Just like when we’re driving, there are times when we exceed the speed limit (except in certain states, but that’s another story), and then there are times when we have to keep it under.

How do you know what the limit is in your trading? Well, first try to imagine the largest drawdown you would be able to handle. If you backtest your system you can easily find out historically what the largest drawdown was. That percentage is the highest amount of your account that you would trade at any one time, meaning all your open positions would not exceed that number.

In backtesting (and actual trading) our TVO System was able to recover from drawdowns as large as 30%, so we’re constantly eyeing that number as a maximum risk level.

We’re using 5 different systems and since there are usually 2 or 3 open at the same time, keeping each position under 15% allows for more flexibility while maintaining our determined level of risk. Following the speed limit gives us the confidence that if things go south, we know our system has the ability to make a complete recovery.

The effect of leverage with options can indeed exponentially increase your return on investment (ROI), but it is the risk of ruin (ROR) that you really need to watch out for. Also, keep in mind that it takes a 100 percent gain to recover from a 50 percent drawdown. Having an optimal position size is just as important as any edge you’ve come to develop in your trading.

Along with being a great driver, proper position sizing is what keeps the car on the road and running for many more trips to come. –MD

Sign up for a 30 day free trial membership and download the Options Position Sizer today!

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