Position Size and Cash at Risk

Hi Mark,
I am still having a hard time determining IC risk and therefore the the initial position size. Let’s say that I don’t want to risk more than $2,000. if I take a position that has a maximum loss of $2,000, it wouldn’t reflect the true risk because adjustments are planned and the position is unlikely to reach the full loss. Thus, I would be trading less than my optimum size.

I plan to exit when no more adjustments are justified and the current loss is approaching my mental money stop level, $2,000. But I don’t know in advance what adjustment(s) will be made, how much cash they require, whether I will have chance to roll-up the winning leg etc. So how do I determine how many lots to trade?

I currently trade 4-5 LOTS of a 10-point RUT iron condor, and I’m comfortable with that. However I have no idea how to size my trades when the iron condors are very different (one week expiration or high-delta, high premium ICs).

When you own stock – and it moves to a certain price (your limit), you know that the stock is not behaving as expected and the position is closed.

Option trading is similar when the underlying makes an unfavorable move. We exit the trade.

However, there are situations unique to options. We may have a loss, but our instincts may tell us to own MORE of a given trade at the current price. Good discipline prevents us from adding to the trade, but it doesn’t feel right to exit. This occurs when we are short vega, as with an iron condor, and implied volatility rises. The stock price may be unchanged, our position may be very near delta neutral, but we are losing money due to being short vega. I would not exit the trade and I do not believe this is a lack of discipline.

When trading options we must look at more than how much money has been lost. We must consider current risk, the reason for the loss, and the future prospects for the position.

Note: You cannot decide that you love the price just because the credit is larger than the initial trade. You should not be trading market-neutral strategies and decide that it is okay to hold a very non-neutral delta position. That is why sticking to strict limits when trading options, such as 1-2% of the portfolio value, is more complicated than when trading stocks.

I am NOT suggesting that you take extra risk. Buy you will not always know the price point for exiting in advance.

As you indicated, we do not know how the trade will play out or whether any adjustments will be made. But those adjustments affect the final profit/loss numbers.

When an adjustment is made, be flexible. Here is how I look at this situation:

When I buy a 3-month iron condor and collect $250, I plan to exit and take the loss when it costs ~$500 to $550 to cover the position. Maximum loss is $250 to $300 per spread. I would feel comfortable trading 7-lots when my maximum acceptable loss is $2,000.

How well do you like the trade?

All spreads are not created equal, so do not trade maximum position size for each position. Assuming that some trades look far better than others, Instead of always trading 7-lots, I would trade 4 to 7 lots, with an occasional 8-lot when the trade is especially inviting.

Allowing for an adjustment

When making an adjustment, I pay a cash debit by rolling down. For conservative investors who do not want to lose more than the specified amount I suggest reducing the buy-back price so that the total loss does not exceed your target. Thus, if it cost $125 to roll, then I would plan to cover when the spread reaches $400 to $425. [+$250; -$125; -$400 and the loss is $275]. I would still trade the same 7-lot as my optimum size

the aggressive trader can think this way:

    –I can adjust or exit when appropriate.

    –If I deem the spread good enough to adjust, then I treat it as a new position and plan to cover at that same $500 to $550 for the whole iron condor. Yes, this increases my maximum loss for the entire trade, but an aggressive trader sees it this way:

    An extra investment was made because the position was deemed worthy, and the adjusted IC is treated the same as any newly opened position.

A lot of this is determined by the trader’s mindset. So rather than focus on exactly how many to trade when opening the position, be more concerned with which risk-management plan feels right to you and your comfort zone. You can limit losses and seldom get into trouble. Or you can be less conservative and invest more money when the position looks attractive.

I’ve used a lot of words to say that holding option positions is not similar to buying (shorting) stocks or futures. Time decay and volatility are unique to options and there are going to be situations in which money has been lost but a position is still worth holding. Violating stop loss prices with stocks shows a complete lack of discipline and must be avoided. When a stop price is reached for an option position, do exit when the loss is due to market movement. However, if the loss comes from a big change in implied volatility, there may be some justification to hold longer. Good judgment is required. As a result, we may discover that we incur a loss that is a bit beyond out limit.

The Rookie’s Guide to Options, brand new 2nd edition. Revised and expanded.

2nd edition cover

2nd edition cover

2 Responses to Position Size and Cash at Risk

  1. James 06/21/2013 at 8:48 PM #

    Thank you for your informative postings. I have a question for you: Yesterday, 6/20/13 the NDX closed at 2890, with settlement this morning on the opening prints. At 4:15pm yesterday the 2875/2865 bull put spread mid-price was $1.25. And just seven minutes before the close that spread could be sold for about $3.50 for only $6.50 risk. Would it not have been a good idea to short the spread because one could keep the whopping $3.50 premium and then could hedge with futures if necessary to cover a gap down open? Would that not have been a good trade yesterday or other days before SPX or RUT settlement with high IV?

    Hello James,

    There are two major point here, and this is such an important question that I want to post the response where more readers can find it. It will be Monday’s blog post.

  2. tom 07/10/2013 at 5:04 PM #

    Very interesting your numbers. You explained very well the looses, but what about the benefits?
    You should have to stay very close to expiration with the IC running because you will need 2 of every 3 Ic to become positive your trading.

    Staying to expiration is just too much risk (for so little gain) for me. However, you may be more comfortable doing that