How Big Should My Options Trade Be?

You’ve got plenty of options strategies mapped. Lots of choices using calls, puts, vertical spreads, and more. But how much should you risk on a given trade, or be willing to risk at any point in time? Something to consider is the concept of utility of your trading capital.

Utility

Economists measure “marginal utility”as the amount of benefit derived from the next dollar. For you trader, it boils down to one question: As the value of your account grows, should risk increase proportionately? For example, suppose your account were to suddenly double in size—say from $25,000 to $50,000. If your typical risk per trade is 5%, would your standard unit size go from $1,250 to $2,500? Should it be more or less than that?

The utility assessment isn’t just for individual trades, but also for aggregate risk. How much of your trading capital do you deploy at a given time? Does that percentage change as the account size gets bigger and smaller? Like many things in life, it depends.

Right-Sizing Your Options Strategy

For options trades, one guideline you could start with is the 5% rule. The idea is to limit your risk per trade to no more than 5% of your total portfolio. For a long option or options spread, it’s pretty straightforward—the premium you pay divided by your account value. If you’ve got $25,000 in your trading account, the 5% rule says you should limit your risk on anyone trade to $1,250. So, if you have your eye on an out-of-the-money (OTM) put worth $2.10 (times the multiplier of 100, or $210), you could buy six contracts for $1,260.

When selling vertical spreads or other defined-risk options strategies, calculating the risk is equally straightforward. It’s the point of maximum loss, minus the amount you’ve collected in premium, plus transaction costs. If you wanted to sell a $5-wide put vertical for $2, your max risk would be $300 per spread. Selling four would keep you under the 5% threshold. To see this in action for any options strategy, fire up the Analyze tab on the thinkorswim^® platform from TD Ameritrade (see Figure 1).

When selling naked (uncovered) options, it’s a little trickier to gauge the risk because it’s unlimited. But you can set a stop order at a level that represents your risk limit. So if you’ve sold five naked put options at $1.50 for a net premium of $750, and you’re not interested in buying the underlying stock if assigned, you could set an alert below the strike price. If the stock falls below it, you would liquidate the short put position. Your max risk would be the loss per contract times five contracts, minus the $750 premium you collected.

Likewise, if you’re willing to set stop orders (and be diligent about sticking to them), you could also consider increasing your contract size on any defined-risk strategy. But with any short position there’s a risk that assignment can happen at anytime. And a stop order won’t guarantee an execution at or near the activation price. Once activated, stop orders compete with other incoming market orders.

After determining your risk-per-trade starting point, think about how much of your available capital should be deployed. And for that, we return to utility.

Utility Revisited: Total Risk/Total Return

We all know Uncle Fred, who at the holiday dinner table freely mixes his entree and sides. Any inquiry is met with a logically sound, but equally unpalatable quip: “It all goes to the same place, kid.”

You could say the same thing about your portfolio. As a general rule, it makes sense to to be more conservative with retirement accounts—401(k)s, IRAs, and other components of our retirement nest eggs—than with trading accounts. This conservative approach typically gets more pronounced as you approach retirement.

Yet, if you were to take a total-return approach to your assets, a conservative tendency in your retirement portfolio may lend itself toward a higher risk tolerance in your trading account.

Let’s go back to the windfall example. Instead of an overnight doubling of your trading account from $25,000 to $50,000, suppose your retirement account size were to double, say, from $200,000 to $400,000. It’s unlikely this would prompt you to double the risk in your nest egg. But you might consider upping the stakes in a smaller trading account.

When you consider total risk as a percentage of your total account value, the marginal utility of your trading account’s dollars might be higher. So if your instinct is to put no more than 30% of your trading account at risk at any point, a rise in your total account value might raise your marginal utility for those trading dollars, prompting you to raise your deployment limit to 50%.

In the end, it all goes to the same place.

Three Strategies as You Raise Your Utility

Suppose you’ve assessed total utility and you’re ready to up your total risk tolerance. You have six open strategies, each deploying 5% of trading assets (a total of 30%). You’ve decided to take that number up to 50%. Consider three approaches:

1. More potential trades. Instead of six strategies, each deploying 5% of available capital, add up to four more.
2. Higher volume per trade. If you’re tied to your six go-to strategies, take the 5%threshold up to 8.33%. Instead of those six OTM puts at $2.10 a piece, you could buy up to 10 of them.
3. More risk per trade. Instead of selling four $5-wide put verticals at $2 apiece,for a total max risk of $1,200, widen the strikes and sell, say, four $8-wide spreads for $3 apiece, for a total max risk of $2,000.

But should you then take on more risk? Not always. You might want to scale into it, because utility works both ways. Changing market conditions and shifting account value naturally affect utility. Check in on it from time to time. And don’t be ashamed to dial it back if volatility, a widening of bid/ask spreads, or a general market downturn push risk utility downward. When it comes to utility players, the name of the game is versatility.