"Live to trade another day".
This is one of the core principles whenever it comes to trading - especially options trading.
While selling options can have a win rate of more than 90%, we should always resist the temptation of taking excessive risks and wind up over leveraging our account size.
In this article, I share more about how I decide what is the position size when I sell options.
Understanding Option Buying Power Reduction
The term, "Option Buying Power Reduction" refers to the amount of capital required to place trades and maintain them.
While there is a way to calculate option buying power, the easiest way is to simply use what your brokerage account provides you with.
For example, if I were to sell a put option on PYPL at a strike price of 70, the buying power effect is a reduction of $700.65.
(Note that this is the way ThinkorSwim calculates the buying power and may differ from brokerage to brokerage)
If you like to find out more about option buying power and maintenance margin, you can find out more about it in this blog post.
So How Do You Portfolio Size
When it comes to selling options, there is a need to pay attention to your buying power.
This is especially if you are selling put options as the option buying power can fluctuate with the share price. This may result in your maintenance margin to increase, resulting in a margin call where you are forced to liquidate your positions.
Personally, the principle behind option selling is to "trade small, trade more". This way, there is little chance where you will hold multiple positions at once and rack up your buying power requirements.
For myself, I like to keep at least 50% of my option buying power available at all times. This is because when I sell undefined-risk put options (i.e. naked put options) - there is a fluctuation of buying power requirement. By keeping at least a 50% option buying power available, it put my hearts at ease that I would not be subjected to a margin call.
Risk Per Entry
The 50% option buying power rule tells the the maximum number of positions you would be putting at any one point of time. For example, let's say that I have an initial buying power of $10,000 - the total option buying power reduction due to my positions should not exceed $5,000.
But how much should you be risking per position? How many contracts should you sell at any one point of time?
Well, the methodology that I use is the 4% mechanical risk.
This means that I am risking 4% of my capital at any time I put my up an option trade. The reason why I am willing to go up to 4% is because of the high probability of profit when selling options.
So here's how it works:
- Let's say I have a $30,000 portfolio
- A 4% risk would mean that I am risking $1,200 per position.
- When selling options, my risk reward ratio is 4:1. This means I am risking $4 to make $1. If you are not sure why this is the case, do read this blog post.
- This means that for every $1,200 risk that I am taking, I am looking to collect $300 in profit.
- For those who have been following me, you know that I tend to close my options whenever I collect 50% option premium. This means that when I sell my options, I need to collect at least $600 (so that 50% premium collection would meet my $300).
- If my premium collected per option contract is $80, this means I will sell around 8 option contracts (since $600/$80 = 7.5 contracts)
- I will put a stop loss to cut my positions when I lose $1,200 from these option contracts.
- I will need to ensure that total option buying power reduction when this trade is placed does not exceed the 50% option buying power rule.
You may have to read through the above a few times to really understand the concept behind it. If you have any queries, do feel free to shoot my an email at ginlim@passiveseeds.com
The Bottom Line
Risk management is one of the most important factors when it comes to selling options. Never ever take it likely or it will punish you severely.
If you like to find out more about creating cash flow using options, I would like to invite you to take advantage of an early bird special to my upcoming Option Cash Flow Course.