There are a few key ingredients to successful trading - trading edge, execution, position sizing and risk management are at the core of it. Most options traders give all their attention to finding that one perfect setup that will make them profitable. But the perfect setup or the so-called holy grail does not exist as such. Of course, a trading edge is a must to survive but trading edge alone won’t help. Position sizing and risk management are equally important, if not more. Position sizing tells you about how much to bet in one single position. It’s a tool to figure out the amount one wants to put at risk in one single trade. Imagine your trading capital is Rs 1L and you buy 10 shares of Reliance at Rs 2,000 a piece (a 20k investment) with a stop loss at Rs 1800. So here, you have sized your position in Reliance with a total exposure of 20k and a risk of Rs 2000. That accounts to 2% of capital loss if your stop loss were to hit. The math is simple for investment but one has to look at concepts like leverage and exposure when it comes to options trading. Let’s look at each one of these in detail -
Margin — Simply put, margin is the amount required to put up a trade. Let’s say Reliance trades at Rs 2000 and you buy 10 shares for delivery, then the margin required for this trade in a normal account will be Rs 20,000. This is a full margin. However, if you want to take this trade intraday only then the margin needed could be much smaller (say Rs 5,000) as the broker would give you margin benefit for it being an intraday trade. Similarly, in margin accounts (in the US), only a small amount is required for margin (even for delivery trades) and not the full value of the underlying.
Leverage — Both margin and leverage look very similar to each other but there is a slight difference between the two. Leverage can be expressed in terms of ratio. In the above example, we got margin benefit and were asked to pay only Rs 5,000 for the underlying value of Rs 20,000 so in this case our leverage becomes 4:1.
Notional Value — Notional value (or exposure) of any position is the total amount of risk for that position. In the above example, if we have taken 10 shares of Reliance for Rs 2,000 bucks each, then the notional value for this trade is Rs 20,000 because if the stock goes to 0, we stand to lose the entire Rs 20,000 and thus the same is our notional exposure of the trade. The broker provided us margin benefits for the intraday trade and although we took the position with only Rs 5,000 in our account, we will lose 20k if the share goes to 0. It works in a similar fashion for options too.
Example 1 — Reliance is trading at Rs 2,000 bucks and you decide to short the Rs 1,800 put for Rs 20. Then the notional exposure for this trade is the amount that one would lose if the stock goes to 0 which comes out to be — Strike price minus the premium, times the contract size i.e. (1800–20)*505 or Rs 9 lakhs approx.
Example 2 -If one sells a straddle or an OTM strangle, then, the notional exposure is underlying price times the contract size or 2000*505 or ~10 lakhs. This is so because only one side will get tested in case of straddle/strangle and not both. Although the notional exposure in case of a strangle is somewhat less than that of a straddle based on the strangle strikes but for simplicity let’s calculate it based on underlying price times the contract size.
Position Sizing - While the rules for positions sizing in options buying and selling could be different, but the underlying idea of how much you are willing to lose in one single position remains the same. Most retailers are attracted to options buying because of low capital requirements and the affair ends in slow burn of capital. There are a number of ways one can size their position in options buying like losing a fixed amount or losing a fixed percentage of account in a single trade, leverage based buying Kelly criteria for position sizing, etc. which readers are advised to read and choose the option that suits them the best. However, the grave mistake that most buyers end up making is buying options with a large chunk of their overall capital. Say an average retailer has 1 lac capital and they buy 4 lots of ATM options of Nifty trading at Rs. 200 and that’s buying options worth 40% of the account size which in itself is a blunder irrespective of the trading outcome as any sizing more than 10% of account size could lead to trouble.
Position sizing for options selling - In options selling, there are defined risk trading strategies as well as undefined risk ones. For undefined risk strategies like short straddle/strangle, short puts, etc., position sizing should be determined based on notional exposure. A conservative trader should not take more than 1.5 to 2X exposure. A moderate risk taker can take anywhere between 2X to 3X exposure. For naked options selling, the biggest risk is a black swan event (could be both on the downside/upside) and if it were to happen, you’d still want to be in business. So, if you size based on notional exposure and stick to 1.5-2X at the start, you’ll survive. Remember purely based on margin required, you could trade up to 5-6X exposure easily. Also have a mix of positions in the account and make it a diversified portfolio. For the risk defined ones too, sizing can be done based on exposure and one could trade up to 4X exposure if their hedges are appropriate.
To conclude, position sizing is an effective tool to keep risk in check and one should always put enough emphasis on it and use it to their advantage in trading.
(The author is a Derivative Trader)
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
