Last week, we discussed how to determine stop loss for option trades. This week, we discuss position sizing- determining the optimal number of contracts to setup for an options trade.
Two per cent rule?
Suppose you plan to buy a stock at 100 with a stop loss at 90. Assume your trading capital is two lakh. The rule is to expose not more than two per cent of your trading capital to risk on a trade. This translates to 4,000 (two per cent of two lakh) on this trade. With 10-point risk (entry price less stop loss) per share, the maximum number of shares you can buy is 400 (4000 divided by 10). You could decide to buy less if you are not confident of the price movement.
The objective of the two per cent rule is to stay in the game longer. If you suffer losses, your trading capital will shrink, lowering your risk-taking capacity and the number of shares you buy. This will prevent you from taking risky bets to recover losses. Conversely, accumulated gains will add to the trading capital, and therefore, to your risk-taking ability. The two per cent cap prevents you from scaling-up your trades if you become overconfident.
This two per cent rule cannot apply for options trade. The reason is because each contract has a permitted lot size depending on the underlying. For instance, the permitted lot size is 250 for Reliance Industries and 1375 for ICICI Bank. As the lot size is fixed and the stop-loss is based on the chart, you must adjust the two other variables- your trading capital and the maximum loss you are willing to take on each trade. Because of large permitted lot sizes, you should, perhaps, adopt a ten per cent rule for options.
Suppose you decide to buy the 2380 next month call on Reliance Industries. Assume your stop-loss is 70 points based on the underlying price. But the risk you are taking is on the option. You must, therefore, translate the price movement of the underlying into the price movement of the option. To do this, you must multiply the underlying price change by the option delta, as delta captures the change in the option price for a one-point change in the underlying. So, 70-point decline in the underlying would translate to 37-point decline in the option price based on the 2380 option’s delta of 0.53.
Note that the permitted lot size of 250 acts as a multiplier when you close the position before expiry. So, a risk of 37-point per option translates into 9,250 per contract (37 times 250). Applying the ten per cent rule, you can risk not more than 20,000 (on two lakh) on this trade. With a total risk of 9,250 per contract, you can buy a maximum of two contracts (20000 divided by 9250). Whether you buy two contracts or just one depends on the profitability of the position- your confidence in the underlying reaching your price target and the reward-to-risk ratio of the position. You can alternatively increase your trading capital to five lakh and adopt a five per cent rule, if 10 per cent is high.
Optional reading
Option price is a function of time value and intrinsic value. While intrinsic value moves one-to-one with the underlying, time value reduces with each passing day, captured by an option’s theta. This means an option cannot move one-to-one with the underlying. The delta captures the approximate movement in the option for a one-point change in the underlying.
There are two important aspects relating to delta that indicates that it is just an approximation. First, delta of an option changes as the underlying changes. And second, delta is a linear approximation to a non-linear payoff. You could adjust an option’s delta with its gamma to reduce the approximation.
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