Decisions. Decisions – Buy The Stock Or Buy The Option?

In trading, size does matter. Could it be that bigger smaller is better?

You’ve heard of position sizing relative to the size of your trading account to minimize losses. If you trade the stock market at all, you certainly should be aware of it. It goes as follows when buying the stock outright:

As a rule, you don’t want to risk more than 2% per trade, 5% max. This number varies depending on whom you read on this topic. It’s still your money, you decide.

What that means is that if you have a $50,000 account risking 2% per trade, than the most you can risk is $1,000 at 2% or $2,500 at 5%. After all, you may want the ability to be in more than one or two trades simultaneously.

Regarding an outright stock purchase, you will never put more than 20% of the account value into any one trade. Let’s say that out of that $50,000 we want to do six trades: $50,000 divided by 6 equals $8,333 in any one trade of which we will not want to lose more than 2 to 5%.

Now that we have our max risk and our total dollar amount per trade, we look at our prospective trade. For example: a stock trades at $20 with our astute analysis we determined a target objective of $26, a stop-loss at $18, giving us a 3 to 1 risk-reward ratio. We now take our gross dollar amount per trade (8,333) divided by the price of the stock. This equals 416. Round it down to 400 shares since we always want to buy round lots. Now, calculate the difference from the entry price to the stop-loss ($20.00-$18.00=$2.00) and multiply it by 400. We get a tidy  $800.00. The $800 is our risk in this trade. We are risking less than 1.6% of the total account.

What if we choose buying a call option (betting the stock is going up) over buying the stock outright? Remember, it’s a choice, your money, your choice, your decision. The number one rule in trading is that YOU are responsible for your trade results:

I can now put in the same $800, $2,000, or whatever I WAS WILLING TO LOSE IN AN OUTRIGHT STOCK PURCHASE into an option trade. The $800 becomes my total investment. The question becomes, how much of that $800 am I willing to risk? Remember, had you bought the stock you already agreed $800 was an acceptable loss.

We don’t want to lose anything if we help it.

However, think it through… if I bought the stock AND I was willing to risk $800 as a loss, wouldn’t this allow me to give my option lots of leeway? I was already prepared to lose it.

You have to be willing to take the risk, obviously.

I follow this one rule: if I wouldn’t sell the stock based on the chart action, then I’m not going to get out of my option position even if it’s down 40% in value. Your tolerance level may be less. I think most option traders will go with a 30 to 40% risk.

Suppose the option trade does drop by $320? My decision to hold or jettison is driven by the stock’s price action, not by the price of the option, and never by the option chart itself. My option trade lives or dies according to the support or resistance levels, or stop-loss parameters that I’ve established on the stock chart.

Assuming I have enough time left in my option before its expiration and the price action is still within my parameters, it is up to me to decide what to do at that point. A caveat: time is your enemy when you buy an option since all options are by definition a wasting asset. See the option disclosure mentioned below.

Options are volatile due to their inherent leverage (100:1), but I already agreed that it was an acceptable loss had I bought the stock. Instead of having $8,000 tied up in a stock trade, I have $800 tied up of which I can lose no more than that amount if everything went wrong and if I didn’t use sell -stops. I can do another trade with the $7,200 still in the account.

I am in control. I can always get out.

These are not rules set in stone except for the “per trade risk amount”. The rules are a starting point for a disciplined approach to trading. If you start playing with options like a gunslinger, you will blow up your account. 

Using position sizing enables us to manage risk. By dividing our account up into multiple trades no one stock can kill us in the chance that a surprise event happens such as earnings preannouncement or geo-political event. Then by only risking a certain percentage, we cut risk even more.

To me, using options, though volatile due to the leverage, is also a way to manage risk.

Read the Current Options Disclosure Document (PDF format).  Here’s one trick to help in learning options, learn the language and terminology of options first. 

Here’s something else to ponder. Trading in options certainly is not everyone’s bailiwick. For one thing, even if I have the stock and it goes against me, I still own the asset. With options, since they have a finite life, price must move in my direction within my time frame or I lose.

If you don’t understand options, get a trading coach.

Visit my options page at wallstwise.com/Options.htm.

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About wallstreetpirate

Thirty-five years in financial services from insurance to registered investment adviser, and trader (now retired). Currently helping wanna-be traders and experienced alike as a trading coach and mentor. I've been in and around, on top of, in the middle of, and on the bottom of the stock market for a long, long time. Here's all I've learned: Trading is about behavior, psychology, and appreciating what the charts are saying technically. You can't fake it. Either you know what you're doing or you don't. And as much as this isn't rocket science, it takes knowledge and a skill set to survive.
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