We will assume that the positions are in puts that we have written. I always recommend that anyone who writes options keeps cash in reserve of 20% of the portfolio in order to cover events such as option assignments.
1. 10 position portfolio of $100,000. First we take out the 20% portfolio reserve which leaves us $80,000 to invest. If we are in 10 positions then we can equally divide that into ten $8,000 trades. The trade size here is measured by the margin requirements. I also recommend that the individual option position always be no more than the amount of stock you would feel comfortable buying.
2. 20 position portfolio of $100,000. Again take out the $20,000 cash reserve leaving us with $80,000. But this time we are investing in 20 positions so our margin allocation to each is only $4,000 which is safer than the position sizes in the 10 stock portfolio above. If we lose 100% of our margin then it is only a 4% portfolio level hit.
3. 40 position portfolio of $100,000. We take out the $20,000 portfolio reserve leaving $80,000 for trading. Now when we take on 40 positions the individual trades can be reduced to $2,000 margin for each. This involves only half as much trade risk as for the 20 position portfolio and is clearly safer in the sense that no one position can hurt the portfolio too much.
Another factor to consider in deciding on the right portfolio size for you is your broker's commission schedule. Most brokers have a fixed or minimum fee that I will call a ticket charge and then a variable fee that increases for each option traded. To keep your commission expenses under control you want to trade in a size that gets you into the variable cost structure so that the ticket charge does not represent your average commission cost. You want to get your cost down close to the variable cost as your average commission. I have found that this means the optimal trade size is somewhere between 5 and 10 options as a minimum. It will obviously differ from broker to broker but the sweet spot is usually somewhere in that range.
If you have a smaller account you may want the account size to dictate the number of trades you have on at one time. Suppose we had a $50,000 account and the average option traded requires $500 in margin. After deducting our 20% cash reserve we have $40,000 available for trading and we want to maximize the number of positions, but make sure that we have at least five options in every average trade. That would mean we should target for $2,500 per trade ($500 X 5). If we divide $40,000 by $2,500 then we get 16 positions as a good number to shoot for.
This content brought to you by TheStreet's OptionsProfits. Click here for a 14-day free trial.
OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits