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Portfolio Position Sizing
The Smart Profits Report: Issue #136
Wednesday, August 18, 2004
Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
Your options positions should find a place in your portfolio next to other higher-risk ventures like gold-mining shares, small caps, technology and the like. This is the high-volatility sector of your portfolio - shares that could make you wealthy or go to zero.
A good rule of thumb is that only 10% of your entire portfolio should be exposed to these kinds of speculative ideas. That way, if everything hits the skids, you are limiting your loss. Within this 10% you must further “portfolio position size” so that you are not concentrated in just one issue or security.
Position Sizing: Trading vs. Investing
For example, if you own 10 positions, each one should be worth no more than 10% of the speculative set-aside - and therefore no more than 1% of your total portfolio. Where most investors go wrong is when they speculate with 90% of their money and invest 10%.
Now, if you only have a $20,000 portfolio, and only 10% or $2,000 is used for speculation, and only 10% of that is in each position ($200), you will not get far quickly with options. Basically, you are on the sidelines until you have grown that portfolio to at least $50,000.
Trust me, with a portfolio that allows only $200 per investment, the commission charges will be enough to keep you out of the game.
Of course, you could play the nickel options market, just like the nickel slots in Vegas. But options don’t reach a price of $0.05 unless they are very unlikely to pay off. With the odds if winning against you to the tune of 80% or more with cheap, short-term options, you are better off enjoying your losses at the craps table in Vegas… where your chance of winning is also better and the nice waitress will gladly bring you a drink.
Trading Options the Smart Way
This may be discouraging news, but it’s not the end of the story. If you are still interested in options you have two choices:
- Stick with ultra-conservative options trades…
- Make enough money to afford an options set-aside…
The rules I just gave you do not apply to all types of options, only those that are held uncovered, or naked. Covered call writing (you own underlying shares of stock as well as an option against the shares) is actually considered by many, including me, as a very conservative strategy for long-term investing.
And if you do have a large portfolio - $50,000 or more in investible assets - then you should explore options further. You may want to stay with the conservative strategies like covered calls, but you can afford some controlled risk, as well.
Just remember, though: Your exposure should be no more than $5,000 on a $50,000 portfolio, and you can definitely set aside less on larger portfolios.
If you have a small portfolio, are new to investing, or you’re just trying to recover from the devastation of the Internet/tech bubble and the flat year we’ve had for stocks in 2004, then you should NOT be involved in the options market.
Wait until you can afford to do so without losing sleep - the wait will be worth it.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- For more on terms like “covered call,” “position sizing” and “LEAPS,” check out our Smart Profits Glossary.
Related Articles:
- Position Sizing - The Most Powerful Investment Concept
- How the Market Makers Lose: Uneven Trades and Open Positions
- Option Position Sizing: How Much to Invest In Each Option Trade
