Happy Mailbag Day!
Several subscribers wrote in this week with the same question. So, let’s get right to it.
How much money should I put into each of your trade recommendations?
Let’s start the answer to that question with the obligatory disclaimer…
The answer depends on how you are as a trader/investor. Your age, net worth, risk tolerance, financial goals and objectives, income, and many more factors need to be considered. What’s right for one may not be right for another. So, you need to trade in amounts that are comfortable for you.
Now, having said all of that, let me share a few thoughts.
Remember, the purpose of options is to reduce risk – not increase it. So, as a simple, general rule of thumb, you can trade one option contract for every 100 shares of stock you would normally trade. If you normally buy 1,000 shares of stock, then buy 10 option contracts (or sell 10 uncovered options as per the recommendation). If you normally trade in lots of 500 shares, then five option contracts will do.
This is an ultra-conservative option strategy. It is what I would tell my mother to do if she were new to option trading. You’ll never overleverage a trade this way, and you’ll never have one losing position blow up your account.
If you’ve been trading options for a while, are comfortable with them, can handle a more aggressive form of trading, and can be disciplined with your position sizes, then let me share with you how I basically trade my own portfolio.
Allocating Capital for Conservative Trades
Let’s say you have $100,000 in your trading account (you may have more or less, but using $100,000 makes the math simple). Take $80,000 and set it aside for conservative trades like selling uncovered put options. The other $20,000 can be used for speculative option buying.
The basic idea here is to attempt to make enough money on the $80,000 conservative side of the portfolio to pay for any possible losses on the $20,000 speculative side. And, if you do well speculating, then you’ll add a nice windfall profit to your account.
Let’s first look at how to allocate the $80,000 in conservative uncovered put option trades…
Take the $80,000, divide it by 10, and you get $8,000. That’s the most you will allocate to any one conservative trade.
I can’t ever recall a time when I had more than 10 uncovered put option positions at work at the same time. Usually, I have maybe four or five trades at work.
So, I almost always carry a large cash position. That comes in handy on those rare occasions – once or twice each year – when stocks reach truly extreme conditions and I have lots of trading opportunities in front of me.
For the purpose of this example, I’ll allocate AT MOST $8,000 (10% of the money I’ve set aside for this strategy) for each uncovered put position.
For example, I recommended selling the GDX August $23 uncovered put options for $1.19 a few weeks ago. The margin requirement for each option contract was $460 (That’s 20% of the purchase obligation to buy 100 shares of GDX at $23). If we divide $8,000 by $460, we get a figure just over 17.
So, in this example, I would be comfortable selling 17 of the GDX puts. Of course, that means I have to be comfortable buying 1,700 shares of GDX – which I am. Your risk tolerance may be different, and you might choose a smaller position. But, most folks SHOULD NOT take a larger position than this.
By selling 17 of the GDX uncovered put options at the recommended price of $1.19, I’ll collect $2,023. And, if the option expires worthless – which is always the best outcome on an uncovered put trade – I’ll record a nice $2,023 profit on the trade.
Selling uncovered put options is a low-risk, conservative strategy. So far in the Delta Report this year, we’ve executed 15 uncovered put option trades (not counting blog recommendations). We lost money on two, and profited on 13. I expect we’ll probably make nearly 30 of these types of trades this year. And we should generate solid profits.
If you’re not taking advantage of this strategy, then you’re missing out on some tremendous returns.
And it is those returns that help to fund the speculative side of the account.
How to Speculate Without Risking It All
Buying speculative puts and calls is exciting. It’s thrilling to think about the potential of earning 100%, 200%, or more in just a few days. But the reality is… most folks who speculate with options lose money.
Most folks overleverage their trades. They take on too large of a position. Then, when the trade goes against them, they wipe out their account.
Don’t be that person.
Take, AT MOST, 20% of your account (in this example, $20,000) and set it aside for speculating. Divide that $20,000 by 10, and you get $2,000. That is the absolute most you should put into any option speculation.
Similar to my uncovered put option trades, I don’t think I’ve ever had more than 10 speculative positions at work at any one time. Usually, I have three or four trades running, and I carry a large cash position.
As an example, on the Cameco September $9 call options I recommended buying in mid-June for $0.75, the absolute most you would buy is 26 options ($2,000 divided by $75). Now, frankly, I might even be more conservative than this and limit the trade to $1,000 or $1,500. But even if you take the $2,000 position, the most you’re risking of your total account is 2%.
If you’re wrong, it’ll hurt to lose $2,000. But it’s not going to wipe you out. And, if you’ve been selling uncovered put options, then your profits on those trades should make up for the loss on an errant speculation.
So far this year, I’ve recommended 13 speculative option trades in the Delta Report (not counting blog recommendations). We’ve profited on six, lost on three, and currently hold four call option positions on gold stocks at about breakeven.
Buying calls and puts is a riskier strategy than selling uncovered put options. But the rewards can be terrific.
The ideal strategy, though, at least in my experience, is to use the bulk of your trading account for conservative trades – like selling uncovered puts. And take the profits from that activity to fund a few speculative purchases.
Best regards and good trading,
P.S. Have you used this trading strategy in your own option account? Has it worked out well for your trades? Send me your responses, along with any other questions or comments, right here.