I've been involved in a discussion with another trader in an online forum. The discussion began innocently enough when the trader stated that, as an option buyer, he would have been better off over the past six years, if he had simply bought options, rather than sometimes buying spreads.
The discussion widened after that and eventually brought up a point that is worth discussing here.
Below are two comments, slightly paraphrased, that were part of the later conversation:
"Option traders think that risking $500 on a spread is
different than risking $500 on a naked position. Five hundred is five
hundred no matter how you risk it."
"the intelligent trader
allocates the same percentage($) of his portfolio to each stock position. He does not buy the same number of shares for each position. I think you will
find a lot of intelligent traders determine position size by cost,
say 10% for any one position."
I agree in principle. A successful trader places the same amount of capital at risk for each position, unless there is a 'special' situation that may call for a slightly larger investment. When trading stocks, there is no chance of becoming confused. If you have a $100,000 account and want to own several positions, it's reasonable to limit each investment to $10,000 or 10%.
But it's not the same when trading options. Let's assume you have the same account worth $100,000 and that you decide to limit the maximum loss for any trade to 5% of your account value.
If you like the idea of buying some ZYX Jun 50 call options priced at $5.00, then the proper quantity to buy is 10. That goes along with your idea of risking no more than $5,000 per trade.
But, if you prefer to hedge the risk of your investment by buying call spreads – instead of just buying calls, you may decide to buy some ZYX Jun 50/60 call spreads @ $3.20. The question is: how many should you buy?
My answer is TEN. Here's why: You believe that it's correct to purchase 10 calls, investing $5,000. The purpose of buying a spread instead of a single option is to hedge the trade, thereby reducing risk. If you buy 10 spreads, you invest only $3,200. Your maximum loss has been reduced from $5,000 to $3,200. That's the purpose of hedging – to reduce risk. Of course, you have reduced your profit potential. Owning 10 calls gives you the possibility of an unlimited profit, but owning 10 calls spreads limits your profit to $6,800* in this example
*The 50/60 spread can never be worth more than $1,000, or the difference between the strike prices x 100
The trader who does not truly understand the difference between trading options and trading stocks buys 15 (or 16) spreads, instead of 10. That $4,800 (or $5,120) investment follows the rule of investing about 5% of his account value in each new position.
The experienced option trader understands that the goal is not to invest $5,000 in each trade, but to trade the position in a size that's appropriate for his/her account. This is based on the assumption that the risk/reward potential for the trade has already been considered and meets the trader's requirements.
If 10 calls is the correct position size when naked long the calls, then 10 is the correct size when the position is hedged. The purpose of hedging (buying a spread instead of just the call) is NOT to allow the purchase of more spreads. The purpose of hedging is to reduce risk, i.e., reduce the cash at risk for the specific investment.
Thus, "$500 is $500" as the forum poster states, but when using spreads, the net investment is reduced so that less than $500 is at risk.
Yes, intelligent investors do limit the size of any investment. But the purpose of using option spreads is to hedge – or reduce risk. That means investing less cash. In return for reduced risk, the trader must accept the fact that profits are limited.
NOTE: This discussion involves buying options and option spreads. Those of you who have read my books know that I am not a fan of option-buying strategies. I know that some traders can do well by adopting that method, but to me it's an unlikely result.
But buying spreads is different. Buying a call spread is equivalent to selling a put spread with the same expiration and strike prices. And both of those are equivalent to the conservative collar position. Due to that equivalence, buying either call or put spreads is a method that's included among my favorite option strategies.