Option Position Sizing
July 28, 2005
The Smart Profits Report: Issue #229
Thursday, July 28, 2005
Option Position Sizing - How Much to Invest In Each Option Trade
By Karim Rahemtulla
Chairman, Mt. Vernon Research
One of the most frequently asked questions from subscribers concerns option position sizing and how much to allocate to each trade.
While the following answer may not be the “clearest” in the world, it should give you a framework from which to base decisions.
What makes this question tough to answer is the obvious fact that each person has a different level of assets, financial sophistication and goals. It’s not like each member has the same income, is the same age and has the same retirement or spending habits.
My rule of thumb is this: Do not risk more than 4% of your investable assets in any one position. That is the starting point for anyone who does not have market experience.
If you are more familiar with the situation or strategy, then you should increase your investment accordingly, but not to more than 10%. Why 10%? Because that is personally the most I EVER risk on any one position. That is my comfort level, based on several years of investing experience and continuous market education.
How Much Can You Afford to Lose?
The amount to invest is just the beginning. The second part of the story is how much you can afford to lose if the position goes against you. Warren Buffett, an investor with vast experience, once said that you should not invest in anything if you were not willing to endure at least a 50% loss - before recovery or with no recovery.
My take is as follows. If you are trading stocks, your stop loss should be between 15% and 25%. The 25% number should be reserved for situations that are effected by non-direct issues - for example, a terrorist attack that effects the entire market but has no direct long-term implications for your individual stocks.
For options, you should use a much wider stop loss because of the leveraged nature of the beast and the lower dollars at risk.
Options Need Wider Stop Losses - MUCH Wider
For example, on my LEAPS picks we always begin with a 50% stop loss. Why? Look at it this way…
If I am investing $40,000 for 1,000 shares of a stock, and using a 20% stop loss, I am limiting my loss to $8,000.
If I bought a LEAP for $4 with two years to go, my total loss, IF I were to “lose everything,” would be $4,000, or half that of the stock investment. Of course, because of the time factor and the limited dollars at risk, I am willing be to be more liberal with some of the stop losses.
How Short-Term Options Render Stop Losses Useless
On a short-term option - one that expires in a couple of weeks or a couple of months - it is a crapshoot as far as I am concerned. And that being the case, a stop loss is usually useless. On the flipside, you should be investing the LEAST possible dollars on this type of trade, as it is, in my book, the most speculative trade you can make… albeit the one with the highest return potential.
The Secret to Position Sizing & Allocating Toward Whole Strategies…
As far as how much to allocate to an individual strategy, the answers are just as ambiguous. I will only speak to my strategies, The LEAPS Option Trader and The Income Trader - A Covered Call Strategy.
LEAPS: For the LEAPS trader, most picks are in the $2 to $3 range, with some under $1 and some over $3. We will use $2.50 as an average per-contract entry price.
We are after two types of wins in the LEAPS service. The first is a straight play - a buy and then a sell. In this type of play, I am looking for gains of 20 to 50% in the short term (less than six months on a one-year option, and 12 to 15 months on a two-year option). In this case, my recommendation is five to 10 contracts per trade, or a commitment of $1,250 to $2,500.
In total, the investment needed to participate fully in the strategy is about $15,000, assuming five to six open positions at any one time. Remember, that money would be equivalent to investing about $200,000 if you were to buy the underlying shares instead.
COVERED CALLS: For the covered call service, my guideline is between $5,000 and $10,000 committed to each trade. The more the better, as far as I am concerned…
So far this year we’re almost batting a thousand on our picks, with an average return of between 1% and 2% per month. As you can see, a lesser amount, say $2,000, would be affected adversely by transaction costs.
I estimate that transaction costs account for about $60 to $90 total so far this year for the covered call service. So, on a trade of $2,000, with a 12% return in six months, you would be netting $150 - not bad, but not much to write home about.
On $10,000, you would net more than $1,100 - not bad for six months with better-than-average downside protection…
In the end, position sizing and dollar allocation are subjective and depend on your financial position and goals.
What is not subjective is the actual act of investing your money. If that is not done objectively, then all the sage advice in the world will not help you.
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Today’s Smart Profits Crib Sheet
- Looking for more information on position sizing? Check out Smart Profits #193, Position Sizing - The Most Powerful Investment Concept.
- Check the Smart Profits Glossary for more information on any options terms that you are unfamiliar with, like “position sizing” or “LEAPS.”
Good Trading,
Karim
Related Articles:
- Options Are Set to Run Full Tilt… LEAP Now
- How the Market Makers Lose: Uneven Trades and Open Positions
- Prevent Corporate Lies From “Cooking” Your Portfolio
Fundamental Analysis
July 26, 2005
The Smart Profits Report: Issue #228
Tuesday, July 26, 2005
Fundamental Analysis - Three Screens For Technical Traders
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research
I am a quant. In trading terms, that’s short for “quantitative analyst,” and means I base my investing decisions largely on stats, probabilities, numbers, angles, slopes, etc., that are often completely computer generated.
But that doesn’t mean I don’t take advantage of fundamental analysis - good old-fashioned sales, price-to-book ratios, price-to-sales ratios, debt and other similar factors related to the fundamental health of the companies.
Today, I’m going to reveal to you the three fundamental analysis “screens” the world’s best quants use to increase their probability of success with every stock and option play.
Let’s get right to them…
Fundamental Screen #1: Turn Up the Volume
We pull from a basket (or list) of stocks for our buys and sells. Putting that list of stocks together is a multi-step process. What we do is called “screening.” And when we screen, we are looking to see that the stocks we add to our basket have volume, first and foremost.
If the stock does not trade frequently, I sure don’t want to be the one holding the “bag” when no one else is interested in holding the stock. Furthermore, if the stock doesn’t trade and we move into it like a pride of lions attacking a pack of gazelles, then the price of the stock is going to move up fast and only some of us are going to be able to acquire it.
Fundamental Screen #2: Increased Sales and Profits
The next fundamental things we look at in some of our screens are sales increases and profitability.
We like these two screens for obvious reasons:
- Year-over-year sales increases show us that it is a growing business.
- Profitability shows us if the business is viable and is making or bleeding money.
Fundamental Screen #3: Sector Performance
When the stocks we screen pass the test, we then load them into our stock database and separate them by sector.
We look at sector performance… then we look at how the stock is performing in relation to the sector. Of course, we prefer stocks that are outperforming within hot sectors.
Why Fundamentals and Options Profits Go Hand-in-Hand
Okay, so now we have our fundamental screens done. In many cases, this is enough. We don’t need to know everything about the company. We just want to protect ourselves as best we can.
We don’t want to enter into, or recommend, illiquid stocks or options on companies that have no business, or future sales, or profitability prospects… We don’t want to take unwise risk.
Bottom line: If fundamental market forces lead a stock and the stock acts correctly within the market cycles, then our statistics and probabilities have a good chance of playing out to our advantage.
When it comes to options, we are usually looking to get a move of at least 20% out of an option after brokerage commissions and the spread are both factored in.
Knowing that options can lose value quickly we like to stick to fundamentally strong companies, in many cases - that way, if the company opens up OR down, we have a good chance of the options moving our way sometime prior to expiration.
If the fundamental screening is done well, and the timing is right, and our systems pick the stock at the correct juncture… then we get what we want, a winner!
Even an old “quant” like me understands that proven formula… and now you can put it to work in your own portfolio, starting with the three screens above.
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Smart Profits Report Crib Sheet
- For more great information on volume, check out Smart Profits #200, Volume - Reading Volume to Find 20% Gains… In 45 Minutes, or Smart Profits #273, Four 2006 New Year’s Options Resolutions to Make Today.
- Check out the Smart Profits Glossary with over 150 options terms, for defintions such as “expiration“, “fundamental analysis” or “indicator.”
Great trading,
Dean
Related Articles:
- Technical Analysis - Two Simple Tools for Spotting a Technical Trend
- How to Overcome the “Evil Twins of Trading”
- Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
Hedging & Speculating
July 19, 2005
The Smart Profits Report: Issue #226
Tuesday, July 19, 2005
Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
As far as I know, there are three ways to use options:
- Hedging
- Speculating
- Generating cash flow income
I would guess that most investors associate options mostly with speculating.
But options are surprisingly versatile investments. You can even use them to reduce risk. Not to mention generating steady income!
Let’s take a look at the three ways you can profit from options, to put each into perspective, including exactly how you can use options as income vehicles simply by selling them instead of buying them…
The Best Way to Speculate With Options
The first way, “speculating,” gets the most attention, and is probably the way most people use them. And it’s also the reason why most people lose when trading options.
The reason why I say this is because most people like to gamble, and options offer you a great way to gamble. Speculating = gambling.
You can buy close-to-expiration, far out-of-the-money (OTM) options for $5, and if the stock makes a huge move, you can theoretically make five, six, or 10 times your money.
This is the lure of buying cheap options. It’s like buying a lottery ticket. If you hit the big one, you’ve won. But the probability of hitting that big one (like winning lotto) is so small that most people end up throwing away their money.
The mentality goes something like this: “These options only cost me $50, so if I lose it, no big deal.” That’s fine if it’s a one-time shot, but if you make it a habit, or part of your daily routine, those $50 losses can add up over time.
You need to be really accurate in your market direction assessment, and you have to be extremely timely, as well.
If the stock doesn’t make the move quickly, your OTM options die very quickly. This is most likely the reason you hear others telling you to stay away from options, because they knew someone who lost all their money playing them.
Speculating is the reason why, as well as leverage. Options offer you great leverage and investors tend to abuse it. If you want to speculate on the direction of a stock or index, take my advice and use deep-in-the-money (DITM) options on two- or three-year LEAPS.
How to Hedge Using Options, Just Like the Big Boys
The second way to use options is through the process of “hedging.” Hedging is a term that refers to a way of protecting something that is already in place. In regards to the investment arena, hedging helps protect any long or short stock position from adverse movements.
If you are long a stock, then one of the best ways to protect yourself against a fall in the share price is to buy put options on that stock. Similarly, if you are short the stock, then you can buy upside calls to protect yourself against a short squeeze.
The strike prices that you select for hedging purposes will coincide with support and resistance levels where you would have set your loss limits if you just outright had the stock without any hedging protection.
There are other more intricate strategies to use, but outright put and call buys are a great way to hedge (protect) an existing stock position.
You Could Use Bonds for Income - But Options Work, Too
The last way to use options is in the form of generating monthly cash flow. This strategy allows you to sell options against an existing stock position to help offset some of the purchase price of the stock, and to give you an extra boost to the paltry interest you’re earning from your bank or brokerage account.
When you sell options, you are the one collecting the option premium and pocketing the money. Option buyers always pay out the money.
The most common form of generating cash flow, and one of the most widely used by investors, is that of “covered call writing.” This is a strategy in which the investor already has long shares of a stock in his account and opts to sell a call option against that position. The strike price is usually out-of-the-money (OTM), which allows the investor to immediately pocket the money, but also gives the stock price some room to appreciate, as well.
Depending On Your Outlook
For the stock, you can tailor how far OTM the strike price needs to be before selling the option. If you don’t want to give up your stock in the case of assignment of the short call option, you would sell a far OTM call that still gives you a decent premium.
You might have to go out to a further expiration month to get it, in that case. Other investors wouldn’t mind selling their stock if it hits a certain price, so they will pick an option strike price at that level. If the stock gets to their predetermined level, they will be assigned on the short call and be forced to give up the stock.
If the short call expires worthless, then you are off the hook for that month and you can repeat the process again. If you employ a rolling strategy of covered call writing, you can theoretically continue the process of collecting (generating) cash flow in the form of option premium to the point where all the premium collected has offset the original cost of the stock. It’s a great way to supplement your income and there are lots of savvy investors out there doing it everyday.
Good luck,
Lee
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Today’s Smart Profits Cribsheet
- Before embarking on an options trading plan, decide which way you want to employ them. If speculating, make sure you are using “risk capital,” or money that you can afford to lose if you are incorrect in your judgment. If you have existing stock positions, consider using options as either a form of hedging or a form of generating some cash flow. Check out the Smart Profits Glossary for other great option definitions.
- For a closer look at using deep-in-the-money LEAPS options, take a look at Smart Profits #202, How to Buy $2,446 Worth of MSFT for $1,270, or swing on over to Smart Profits #180, Deep-In-The-Money Covered Calls - How to Beat Stocks with Less Risk.
Related Articles:
- Index Options: A Billionaire’s Trading Tool Anyone Can Use
- Two Rules for Beating the Market Makers - And Why You Need “Institutional Calm” to Win at Options
- Option Credit Spreads: Sell First, Buy Second for 50% Better Odds
Options Risk Management
July 15, 2005
The Smart Profits Report: Issue # 225
Friday, July 15, 2005
Options Risk Management: How To Know What You’re Risking
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research
Have you ever felt that a position you’ve been eyeing for quite some time is going to go up in price, but worried that the stock is volatile and you don’t have the capital? Or, you don’t want to commit the capital to the position if you have to buy the stock?
Relax. You don’t have to. Just buy the CALL OPTION on the stock.
First things first, though. Let’s not discuss the “why is the stock going to go up” idea, but the timing. You see, buying options, whether they are puts or calls, has a lot to do with timing and management.
What I am talking about here are positions that you think may go up or down dramatically over the next one to three months. You know when you get that feeling, or you read the research report that just jumps out at you - right off the page - and you really want to take that position… but the downside and risk are pretty scary if you were to hold the stock itself.
Employing Options Risk Management
So the timeline is set at about 90 days. You really think that your chosen stock is going to skyrocket from, say, $50 per share, up to potentially $60 per share, within 90 days. The only problem with the picture is that you have also seen the price of the very same stock get hammered by a relentless and unforgiving market. Risk management is needed here. Furthermore, it’s a $50 stock and you either have limited funds, or you don’t want to expose yourself to a quick downturn where all you buy is 1,000 shares and you wake up one morning to find your hunch was way off, and you are sitting on a $10,000 loss.
Look at this scenario: Merrill Lynch (NYSE: MER) is a $55 stock at the time of this writing. The August $55 calls are selling for only $1.45. So for just $1,450 you can control 1,000 shares of MER by buying 10 call option contracts.
The move is not going to be one dollar in gain for one dollar in profit. That is the first thing that you have to understand. Next, your downside is capped at a loss of $1,450. You can only lose the amount of money that you put into a call option. Even if the stock goes to zero… you only lose $1,450.
That’s a good trade-off in my book, and it’s why - even when speculating with options - they can have insurance-like qualities that mitigate some of the risk, since the amount you put in the CALL option is the MAX that you can lose in the trade.
Options: Less of a Risk than Stock Trades?
Isn’t placing a call option better than getting involved in a trade for 1,000 shares of MER at $55, and having to put out $55,000? Of course, we wouldn’t expect MER to go to zero, but a 30% drop in dire circumstances is not out of the question. That means that you are still exposing yourself to a hypothetical loss of $15,000 or more, while having to deploy and tie up about 35 times more money as well.
If you are becoming involved (or looking to become involved) in a volatile stock, with both upside potential and downside risk, then options are usually a good instrument to use in place of buying the underlying stock.
So next time you have a hunch, don’t take a chance - use options risk management. Calculate your risk, and take an option.
Good trading,
Dean
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Today’s Smart Profits Cribsheet For a definition of options terms used in today’s report, check out the Smart Profits Glossary. Related Articles:
- Rent ‘Til You Sell - How to Double Your Stock Profits with Options
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Options On ETFs
July 12, 2005
The Smart Profits Report: Issue #224
Tuesday, July 12, 2005
Options On ETFs - Increased Safety and Profit Potential
By Dean Albrecht
Advisory Panelist, Mt. Vernon Research
With any equity, you have options…
You can of course simply buy the underlying equity instrument (the stock), such as Texas Instruments…
Or you can buy a highly correlated but less volatile instrument, such as a semiconductor ETF (Exchange Traded Fund) to lower your volatility. Such a fund holds a basket of semiconductor stocks like Texas Instruments and spreads risk.
But the strategy I like, especially with higher ticket-price stocks, is to trade options on the correlated instrument, rather than buying or selling options on the stock itself. This gives you several advantages:
- High correlation to the stock…
- High potential returns through the leverage of options…
- Less money at risk in the lower-priced options, plus increased safety through diversification in the correlated instrument.
Let me explain how this works, with a trade on the Nasdaq ETF (Nasdaq: QQQQ), otherwise known as the “Q’s”…
An Options Play on the Nasdaq ETF
A couple of weeks ago, I told my clients to buy the QQQQ put options instead of issuing a short on the Nasdaq ETF itself.
Why the put options instead of selling short the ETF?
The downside move of the QQQQ (the underlying instrument) was expected to be, at most, about 2% - or 70 cents.
However, the put was selling for about $1.20, and if the QQQQ retreated as expected (down to, say, $37.20 from $38), then the put option would increase in value to about $1.75, for a more than 40% gain.
A Note About How Delta Works
Which brings up a question: Why does the QQQQ itself drop, say, 90 cents, and the option only moves 60 cents?
This is due to something called delta. Delta is a fancy word for the amount by which the price of an option changes for every dollar move in the underlying instrument.
For example: If the QQQQ moves $1, then the option price with a delta of 0.70 will move 70 cents. It’s really simple, and in my opinion an important issue to take into account when buying an option.
If you buy an option, you want movement - it’s the only way to capitalize on the situation. The option doesn’t move by quite the same amount - but the option is usually MUCH less expensive. So the percentage moves are usually pronounced.
A Delta of More Than 0.60 Is a Good Start
When I look at an option, I immediately look to see that the delta is more than 0.60 because I want to take advantage of the expected move in the underlying instrument and receive a higher percentage gain.
Most often, I am looking to take options positions in stocks that are expected to move in a certain direction, by a certain amount, in a certain time frame. So I usually take positions in near-term positions that are in the money or at the money.
The QQQQ’s move in a range of about 7% per month.
When buying the options instead of the stock I can still take advantage of these tight moves, as the spreads on the QQQQ options are low and the liquidity is very, very high.
Here’s how I do it… The near-term option that is in the money or at the money would garner a cost of about $1.25 or $125 per contract, to control 100 shares of the underlying stock - instead of $3,800 to control the same amount of stock by buying the underlying QQQQ shares.
High Deltas and Bigger Percentages
Why do I like options that are near the money or in the money?
These options tend to have a high delta, and it gives the opportunity to take advantage of the move from a percentage gain perspective.
Without even looking, you will start to learn that the DELTA on near-term options that are at the money, in the money, or close to the money usually ranges between 60 to 70. Once again, this means the price of the option will move about 60 or 70 cents for each $1 move in the stock.
Now let’s take a look at how we might come out of the QQQQ trade…
The stock play for our 3% expected move on an option with a delta of 0.70 would garner an expected move of about 75 cents, or about 60% on the option. I sum it up in here:
- Stock: Nasdaq: QQQQ (the Nasdaq index fund)
- Expected Move: 3%, or 1.20
- Expected Time Frame: 3-10 days
Armed with that information I can now make an educated and informed decision on whether I want to take the position in the option or in the stock.
And trust me, the option position usually wins out when you have a good idea of price direction. In this case, that could equal a nice 60% return in less than two weeks.
Good trading,
Dean
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Today’s Smart Profits Cribsheet
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Check out our Smart Profits Glossary for definitions of words like “ETF” or “delta” found in today’s article.
Related Articles:
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Options Leverage - How to Use Delta to Maximize Your Leverage
- Trading Index Options - Two Ways To Profit
LEAP Option Investing
July 8, 2005
The Smart Profits Report: Issue #223
Friday, July 8, 2005
LEAP Option Investing: The Best Options Play on eBay
By Karim Rahemtulla
Chairman, Mt. Vernon Research
One of the reasons I love LEAP option investing is their ability to withstand severe shocks to the underlying stock - and still have upside potential.
With short-term options, you are often sunk unless the trade goes your way. Any unexpected news, earnings disappointments, competitive threats, etc., could turn a once promising investment into a loss in no time flat.
I have seen it time and time again… A company is sailing along and everyone is making money. The stockholders are happy and so are the options holders. In fact, there’s nothing but good times ahead. Then, out of the blue… news hits that is detrimental to the company’s prospects over the short term. The shares sell off only to recover within a few weeks or months as the information is processed and investors return to their senses.
Google, eBay, PayPal… And How to Maximize Your Returns
A good example is the recent news that Google would launch an online payment system. Immediately, shares of eBay, which owns PayPal, sold off sharply. Investors reasoned that Google would pose a nasty threat.
There was no attention paid to how big PayPal was, or how long it would take for this beta test from Google to become reality.
When all the facts are out, investors may realize that they sold eBay a little too quickly and without thinking through the ramifications - including the fact that the market is so large, competition may not be such a bad thing to attract new users.
Anyway, I will save that story for another day.
Short-Term Players Are Toast But Not The LEAP Option Investor
What is important is that investors holding short-term eBay options are basically toast. Chances of eBay recovering its losses in a week or even a month are not very good in this low-volatility market…
Especially when the legions of nervous and jittery short-term traders out there remain inclined toward bailing.
However, if you were a LEAP option investor holding an option that had a year or two left before expiration, the downward move in eBay options, while painful, might not be the final word.
After all, a stock like eBay, which can fall 20% in a week, can also rise 20% in a week. The 52-week range between high and low is almost $30 - that is a lot of room for growth in share price if the company performs and regains favor. In this fickle market, anything is possible.
So, the LEAPS investor is still in the game, while the short-term player is out.
Why Using LEAPS Also Beats Stocks
Not only that, but the LEAP option investor has a critical advantage over the shareholder, too, since the LEAP investor most likely invested 5% to 10% of what the stockholder has at risk. While eBay fell $4 the week of the Google announcement, the LEAPS may have fallen $1 or $1.50, depending on the strike price and expiration.
On a 1,000-share position, that would be a $1,000-$1,500 loss, versus a $4,000 one.
If you are investing in a stock with an outlook of only one or two years, then you should consider using LEAPS. If you don’t use LEAPS, then you are investing 90% more than you have to, and you are risking 90% more than you really should.
Good trading,
Karim
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for definitions of terms like “LEAPS” or “expiration” found in today’s article.
- For more on LEAPS check out Smart Profits #159, LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns.
Related Articles:
- LEAP Options: The Intel Bargain & A Potential 566% Return
- Option Trading Strategies - Option Plays That “Earn” Their Keep
- Option Position Sizing - How Much to Invest In Each Option Trade
Hear It From Our Premium Members...
who you have been vastly outperforming. I did very well one of your recommended positions,
one of the few good positions I've had this year. Good job. Keep up the good work!
Cheers, Regards,
"
~Bud
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Just wish that I would have put more $$$ on it oh well.
Thanks"
~Paul K.
