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Position Sizing Ideas for Naked Short Options

When putting on positions with undefined risk (naked short puts, or short strangles, for example), one question I often get asked is: “How do you determine your position size?”

This is perhaps the most important question to ask when putting on these types of trades!

I have two imprecise, imperfect ways that I decide:

The first method is a quick-and-dirty, non-optimized, and usually more aggressive method.

I’ll target a trade-entry credit that I want to collect upfront based on a percentage of my trading capital. Generally speaking, I want to collect 1%.

If I have a $100k account, I’m looking to collect approximately $1,000 of net credit for the short put or short strangle trade (equal amount of short out-of-the-money calls and puts) I’m initiating. However many contracts I need to trade to earn that dollar amount is my targeted position size.

It is important to note that I only use this method when trading indexes or sector ETFs. These products have less of a probability of a sudden overnight gap moving against me, making risk management problematic.

The second, often more conservative method I employ relates to the cost of a long stock position should I get assigned against my short puts. For example, if the position I’m considering involves short puts at a strike price of $50, then that means I could potentially be assigned stock at a cost of $5,000 (100 shares times $50/share) per contract I hold short.

I don’t want the cost of any potentially assigned stock to cost more than 10% of my account value. So, using numbers from above, for a $100K account I wouldn’t want to be on the hook to purchase more than $10,000 worth of stock. If I’m shorting $50-strike puts, this means I’d short two contracts.

If I got assigned against these two short put contracts, this means I’d pay $10,000 in my assignment of 200 shares of stock. In the unlikely event that the stock goes to zero before I have a chance to exit my position, the worst hit my entire portfolio would take would be a 10% hit. That sucks. But I can recover from that.

And recovering from losses is how we succeed in this game.

Whether I employ the first method or the second, whenever I’m in doubt, I’ll always trade smaller. It’s just good, common sense. These trades are never designed to be home-run profits, so I certainly shouldn’t allow them to take me out of the game!

Trade ’em Well,

Sean McLaughlin
Chief Options Strategist
All Star Charts, Technical Analysis Research

The post Position Sizing Ideas for Naked Short Options appeared first on All Star Charts.





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