Size Really Does Matter

Mark,

I use a position size calculator that I made in Excel. It tells me how many contracts I can trade, keeping always the max possible loss constant (in this case $6000 per trade).

As far as your comment about making an adjustment that increases the number of contracts from 40 to 60 is not quite clear to me. I mean, suppose that I do not have to adjust and instead, I want to add a second trade in my portfolio. If I buy an IC with the same premium as the first one (ie 0.50 for a 2-point SPY iron condor), using the size calculator, I will buy again 40 contracts. So, I will have in total 80 contracts in this case.

When you own two 40-lot iron condors, you may have established the maximum risk at $6,000 for each trade, and you may have an initial margin requirment of $8,000 ($200 margin per 2-point iron condor) for each trade, but the type of adjustment that you suggested (cover a portion of the short call spreads and sell a larger quantity of farther OTM call spreads) increases both margin and maximum risk.

This is also true when you adjust a 40-lot trade to a 60-lot trade.   Your maximum loss becomes MUCH larger.

As long as this is a paper-trading account, I recommend that you trade some 4-lots of 20-point SPX spreads instead of always choosing 40-lot SPY trades.  Learn how it feels to trade the bigger index.  Adjustments may be more difficult, but you save a lot of commission dollars.

 

 I started my paper trade portfolio with $200,000. Then I said that I will allocate 30% ($60,000) of the total portfolio for trading options (90 day iron condors). I will risk 10% of that allocation ($6000) for each trade.

If $60,000 is the amount allocated to trading iron condors, then there is no reason to have $200,000 in that account.  It requires massive discipline to not exceed that $60,000 limit when you either find an outstanding opportunity, or more likely, run into trouble and require more margin. 

Worse yet, a nice little winning streak can boost confidence and result in your trading 60-lots instead of 40-lots.  The problem is not with having a winning streak. The problem is that winning steaks tend to result in traders increasing risk and trade size by too much, and far sooner than is prudent.  When you have extra cash available, it's tempting to use it.

Keeping that $140,000 in a separate account – so that you must manually make a transfer to get your hands on that capital, is a nice safety play.  The cash is there if you truly want to use it, but it cannot be accessed without making a direct decision to do so.

When the premium is higher I trade more contracts, when the premium is lower I trade fewer contracts – but the max risk is always the same ($6000).

You may want to reconsider.  Just because the premium is $0.52 instead of $0.50, it does not mean that you must push the envelope and trade 41-lots.  This is still true when you collect an even higher premium.  You are very new at this game, and you are looking at far too many variables at one time.  Learn now.  Save refinements for when you know enough to make educated decisions.

I will make two trades each month.  Therefore I will own no more than 6 positions at any one time, w/o counting adjustments, in my total portfolio of 90 day iron condors.  I will risk max $6000 per trade or $36,000 for the whole portfolio.

Going back to your example (in your initial comment), when you buy (to close) 13 of your short call (or put) spreads and then sell 33 spreads that are farther OTM, the margin requiremnt has increased by 20 x $200, or $4,000. 

However, it's your maximum loss that is now out of kilter.  You can lose $150 each on your remaining 27-lot iron condor.  Plus, you can lose $180 x 33 ($5,940) on the new call spreads.  That places the max loss at $10,000 – not counting the loss already taken on the 13-lot. How does this adjustment maintain that $6,000 max loss requirement?  Making an adjustment does not release you from your limits.  Adjustments are made to reduce, not increase, risk.

Not only does this jeopardize the safety of your account) because it's likely that you will want to adjust more than one position at the same time – or almost at the same time, and you do not have the experience to make a judgement about whether that risk increase is justifiable (as a special situation) or whether it's so risky that you should never make this trade.  Not if you want to pretend that you are paying any attention to managing risk.

Please understand.  If you want to trade this way, if you are willing to take on the added risk you do get something in return.  You do get the increased probability of earning a profit each month.  Plenty of amateur traders trade this exact, higher risk path.  Even some professional traders may adopt this adjusment method.

However, they know when to do it and when not to do so.  They have a firm grasp on risk management and know when it's reasonable to add to risk and when it is verboten.  As a paper-trader with zero experience, you cannot expect to learn enough (in however many months you dedicate to paper trading) to have a very frim grasp on risk management when using real money.

For your safety and sanity, I suggest that this plan is not viable.  Not now.  Not without much more experience and knowing how skilled you are when it comes to making difficult trade decisions.  I'm excited for you that you have a plan, are thinking through the possibilities, are asking questions.  That's all good.  But I believe you fail to see the risk involved with the methodology suggested.

This leaves me with another $24,000 available for adjustments.

Good.  A very reasonable sum.  It should be enough, but not if you use large chunks of that extra margin every time an adjustment is made.  Be careful not to stretch the limits – because if you are thinking of going all in with that margin, it's likely that your risk is going to be far higher than your 'maximum.'

Does this make sense? Again, thank you very much for your support.

Yes.  It makes sense.  But not for you.  This is not the path to learning the importance of risk management.

Dimitris

***

This question, and part of the reply has already been published as a recent comment and answer.  However, many readers see Options for Rookies only through an RSS feed, and the comments are not avaiable through that source.

This post is important to traders who routinely adjust positions by increasing position size.

Size matters.  Size kills.  Traders who are capable of handling moderate risk can easily panic when positon size becomes too large and gigantic losses (gigantic for the specific trader) loom.  Please be careful.  Managing money and limiting risk are essential skills for every successful trader.

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10 Responses to Size Really Does Matter

  1. Dimitris 10/14/2010 at 8:50 AM #

    Mark,
    Thank You so much for coming back to my original question with an even more detailed explanation. I count myself extremely lucky for having found an experienced and wise man like you, who genuinely cares about the education of amateur option traders.
    As a clarification (not that it changes the reality as you very correctly analysed it), in my original question, thinking about my plan, the adjustment part was just closing 13 contracts (out of the original 40). Selling a new spread (33 contracts) was a completely separate action to take advantage of the move in SPY (from 113.50 to 122).
    Again, the facts remain the same, that I increase a lot my risk (the 2 trades, initially planned, become 3 and the max risk increases from $12000 to $18000). It is crystal clear to me now that this is an action to avoid.
    Thank You

  2. DC 10/14/2010 at 10:21 AM #

    Hi Mark,
    I have a question on ITM options that I was hoping you could clarify for me.
    If my expectation is that a stock will go up and I buy a deep ITM call (to minimize the risk of time decay) and the position is still open during the last week prior to expiration, are there any adjustments that can be made to this position if the stock gaps down and goes in the other direction (bearish)during that week?
    Also, if my expectation is bullish when I enter the trade, would it be a good idea, as a general rule, to buy a protective put (OTM or ATM put) at the same time that the deep ITM long call is bought in order to minimize the risk of the position losing value if the stock gaps down? Or is it always better to wait and only buy the protective put if the stock goes bearish?
    I also have another question on profit/loss graphs. When I was analyzing different positions using a PL graph, I noticed that if I buy an ITM call and an ITM put, the risk graph for that position looked very similar to the one constructed with OTM options at the same strike prices. The only difference that I can see is that the max risk at expiration is higher with the ITM options but the curve is very similar. For example, if the stock is at 140, the rate at which the position loses or gains value (as reflected on the PL chart) for the IBM Nov ITM 120 long call, IBM ITM 150 long put appears to be very similar to the one constructed with an IBM Nov OTM 150 long call and an IBM OTM 120 long put with the only difference being that the max risk of the OTM position is lower. If the ITM trade is constructed with options that have higher delta, shouldn’t the rate at which the call and put increase or decrease in value be higher than the OTM puts/calls? Also, since the OTM trade is obviously much cheaper, is there any advantage of using the “more expensive” ITM options in this type of trade?
    Thanks,
    DC

  3. Edgardo 10/14/2010 at 1:14 PM #

    DC….
    Are we talking Strangles here?
    Analize it a little, and you will see that if you use the ITM in your example, if the value of the stock at expiration is in “inside” the 2 strikes, the value will be 30, so if you paid 38, you will lose just 8
    If you do it with OTM, you will pay just 8 instead of 38, and that is the maximum you could lose.
    Both positions have the same risk/reward (in $), suppose Stock is at 110 at expiration, you sell OTM position in $10, winning $2
    In the ITM, you sell the position at $40, winning the same $2
    BR
    Edgardo

  4. Mark Wolfinger 10/14/2010 at 9:52 PM #

    Dimitris,
    Yes. A choice to avoid – but it is occasionally acceptable.

  5. Mark Wolfinger 10/14/2010 at 10:07 PM #

    DC,
    1) Once the stock has gapped down there is not much you can do about it. It’s too late.
    But – prior to the gap, there are precautions you can take.
    a) As your call moves deeper ITM, it can be sold and replaced with a new call option (with a higher strike price).
    If you do that, you take cash out of the trade, and thus do better any time the stock tanks. However, if you sell a 10-point call spread and collect only $8 or $9, then you are giving up $1 or $2 if the stock does not tank. Look at this trade as insurance.
    b) You can buy a put option – at an appropriate strike, hopefully at not too much cost, that protects your gains. If the stock is 80, don’t buy a useless put with a strike of 60. You would need as much protection as you want to own.
    2) No it is not better to buy the protective put AFTER the stock tanks. You will have already lost your money and it will be too late.
    But here’s my question to you: Why would you still be holding? How much profit do you need from a given trade? Why hold an option worth $10 or $15? Especially when you plan to sell at expiration anyway.
    3) Look up the definition of a box spread. The position you describe is a ‘guts’ strangle. That’s buying the ITM call and ITM put. If you buy the same strike/expiration – OTM calls and puts, the positions are equivalent.
    When you buy the deeps, you pay a bit of time premium over parity. That’s the same premium that you pay to buy the OTMs.
    The max loss should be the same for either position – assuming the options are priced efficiently.
    The rate at which delta changes is GAMMA. Gamma is very small when delta is near 0 or near 100. It is snot dependent on the delta itself. A 95 delta option cannot change delta too quickly – it can only move to 100.
    The only advantage to using the more costly options occurs when you can buy them cheaply – and that is not likely. Again look at box spreads – or better yet, work out for yourself that these positions are equivalent.

  6. Mark Wolfinger 10/14/2010 at 10:12 PM #

    Edgardo,
    I should not have bothered to reply to DC – your reply does the trick.
    Thanks for providing a great answer.

  7. Rajesh 10/15/2010 at 9:07 AM #

    Hi Mark,
    Further with respect to deep ITM options, I have on occasions come upon situation where they are available for less than parity. I can understand the anxiety on the part of the holder who wants to exit and book his / her profit but there is an obvious arbitrage opportunity here. How can I hedge my directional risk (as a small trader), if I were to buy these? Buying the underlying is not possible since it is an index and one can buy or sell the futures contract.
    Earlier in this discussion, you have mentioned that “As a paper-trader with zero experience, you cannot expect to learn enough (in however many months you dedicate to paper trading) to have a very firm grasp on risk management when using real money.” Now I know you are a strong advocate of paper trading as a means of getting one’s feet wet but psychologically once ‘real’ money is involved with its attendant risks of huge losses and dreams of large profits, the rational mind often gives way to the emotional trader. So you may be a great paper trader but when it comes down to real life trading it may be like learning to trade all over again.
    Rajesh

  8. Mark Wolfinger 10/15/2010 at 9:44 AM #

    Rajesh,
    You should NEVER see an opportunity to buy at less than parity. Others seeking those opportunities have computers searching for them.
    Nevertheless, if you find such an opportunity, do stock as the hedge.
    If you buy 3 calls under parity, immediately buy 300 shares and exercsie the calls.
    If it’s a put, buy stock and exercise.
    Be certain that you are buying by enough under parity to compensate for the trading costs. I cannot imagine that you will be able to do this more than once in your entire lifetime of trading. But. This is not a point of argument, just my option.
    Remember: If you ignore commissions, you will lose money on the trade.
    If the paper trader cannot transition to real money trading, then so be it. For the vast majority, there are two paths to being a successful trader: Get lucky or trade with emotionless discipline. That’s it.

  9. Rajesh 10/15/2010 at 10:08 AM #

    I trade the Indian markets. As the market was dropping like a stone, at least on 5 occasions I found that the 6500 put (when the index was at 6050) was offered for 435 (guess the markets are not too efficient :-)). Since it is an index that is trading and not individual shares, there was no question of buying or selling the underlying. The futures were however trading at a 25(!) point premium at that time. I thought of buying the 6500P, selling the 6500C (34) and buying a future contract (6075). Even with commissions, this would have resulted in about 25 point (free money!). Would this have been a reasonable thing to do? Of course, there are commissions to wind down this whole thing at expiration.
    Normally, I would not post individual situation but this could enable you to answer it more accurately.
    Thanks

  10. Mark Wolfinger 10/15/2010 at 7:57 PM #

    I have no idea whether this works for not. Sorry.