1. Identify your maximum risk. For most debit spreads the risk is limited to the amount of the debit. Ask yourself how much you can afford to lose. That should be an upper limit for how big a position you can afford. For credit spreads the risk may exceed the amount of credit and you should consider the maximum risk. If you do a naked short of a put the risk is potentially all the way down to zero. For a naked call the risk is infinite, in theory.
2. Calculate your delta. In many ways delta is your risk. A delta of .50 means the position will move as though it were equal to 50 shares of stock. Ask yourself how much stock you would be willing to buy. Do not exceed that amount in the equivalent option position. If you would buy 300 shares of stock then do not exceed 6 options with a delta of .50.
3. Do not trade too small. Most brokers have a commission structure that has a fixed fee plus a low charge per contract. In order to keep trading costs low you need to do some size. After about five options, the costs start to get reasonable.
4. Do not trade too large. Keeping costs in mind again, after you get to about 20 or 30 options the costs pretty much converge down to the low cost per contract. After that you are probably better off by going into another trade in order to diversify. Diversification is one of the cheapest ways to reduce risk. It may be the only free lunch left on Wall Street.
Readers who would like a more complete discussion of position sizing might look at my 2008 book Optimal Portfolio Modeling, published by Wiley Trading.
Today's trade is on Dish Network ( DISH) now trading at $21.50, with a forward PE of only 9x earnings.
Trades: Buy to open DISH June 23 call for $1.05 and sell to open DISH March 23 calls at $0.60.
The net debit is $0.45. Consider the $0.45 as the risk and the delta of .10 in deciding on your position size. We are setting the stop profit at a stock price of $23.00.
At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.
Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.
On January 19, TheStreet's OptionsProfits is hosting a webinar featuring John Carter of Trade the Markets. Concepts, citing specific trade examples, will include: market sentiment, technical indicators and trading psychology. We will also discuss how to use options and other asset classes to position and manage your portfolio through 2011.
OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.