Risk Management: Position Sizing with LEAPS Options

This is the final method I am sharing on correctly sizing the position of each trade with proper risk management techniques. Use of LEAPS options for investing comes with lots of extra risk management requirements.

Options are truly a system of win or lose. When held until the expiration date, options are either worth something or they are worth absolutely nothing.

Options have various expiry dates. There are short-term options that can expire within days or weeks. These options are especially volatile in price and not very suitable for a longer-term trend investor.

LEAPS is a acronym for Long-term Equity Anticipation Securities.  LEAPS options are identified as having expiration dates longer than one year from the current date. Although they are still risky, I believe a trend investor can use LEAPS strategies very profitably.

A Brief Concept of Options

Options—sometimes still called warrants on the buy side—are a contract between the option writer (seller) and a buyer to buy or sell a predetermined number of shares at a certain price on or before a date in the future.

When you hold an option, you have the right, but not the obligation, to exercise the option. You may also sell your option in the secondary market to another buyer.

Without even getting into the "Greeks", options are a land of jargon. Here's a brief rundown of the terms which are relevant for this article:

Options Contract:  A contract between the writer and the buyer where the buyer has the right to buy or sell 100 units of the underlying security at the strike price on or before the expiration date.
Strike Price:  The price at which the option can be exercised.
Expiration Date:  The final date when the option is valid. At this time the option must be exercised (if in-the-money) or it becomes worthless.
Writer:  An individual who sells the option.
Premium:  The amount of money paid for the option. It is sometimes called the quote or option price in the secondary market.
Breakeven price:  When the price of the underlying security is equal to the strike price plus the net premium cost.
Call option:  An option where the holder has the right to purchase shares at the strike price.
Put option:  An option where the holder has the right to sell shares at the strike price.
Covered option:  An option where the writer actually holds the underlying security in question.
Naked option:  An option where the writer does not hold the underlying security. (Writing is generally restricted to professional traders).
In-the-money (ITM):  If the strike price of the option is greater than (call option) or less than (put option) the current price of the security.
Out-of-the-money (OTM):  If the strike price of the option is less than (call option) or greater than (put option) the current price of the security.
Near-the-money:  If the strike price of the option is very close to the current price of the security.
Bull spread:  Buying a call option for a certain price and selling an equal amount of options on the same security for a higher price.
Bear spread:  Buying a put option for a certain price and selling an equal amount of option on the same security for a lower price.
Straddle:  Buying a call option and a put option for the same security at the same expiration date.

It is very important to understand that a buyer of options has limited downside, but a nearly unlimited upside. Their downside is limited to the premium they pay for the options contract they buy. Their upside is only limited by time—when the option contract hits the expiration date.

On the other hand, the writer has a limited upside, the premium they collect for selling the options contract, but a nearly unlimited downside. To their benefit, most options expire worthless or are otherwise closed in the writer's favour.

To the options buyer, the skewed risk presents some opportunity. It also makes for easy risk management in most market conditions. You cannot lose more than the premium you pay.

Especially when you start trading options, always buy in-the-money or near-the-money options to establish your position. Although far out-of-the-money options are much cheaper, they are also much less likely to hit the breakeven price.

Several Easy LEAPS Options Systems

Using LEAPS options as a strategy to get long or short exposure to a security should typically be based on a timing system. Although many people shy away from using options, it can actually be a very effective strategy if you take the time to understand how to execute and stay on top of your positions.

The exact system you use to get buy signals or sell signals doesn't really matter. As I have mentioned before on this blog, there are a wide range of effective indicators and none of them are perfect. They will all have losing signals and winning signals.

Some of the easier indicators include using a simple moving average, using a moving average crossover system, a breakout box system, or an absolute momentum system. All of these can be effective when paired with proper risk control.

Long-only LEAPS Options Strategy

The easiest way to use LEAPS options is to buy a liquid in-the-money or near-the-money call option when the underlying security hits a buy signal and a put option when the underlying security hits a sell signal.

Knowing that options can expire worthless if they are not in-the-money on or before the expiration date, you will only purchase the number of contracts which you can afford according to your maximum level of risk.

For example, if you are risking up to 1 percent of your portfolio value per trade, you will only purchase the number of options for this trade where the premium paid is up to 1 percent of your portfolio value.

Then, when the signal turns, you will either exercise the option or sell the option in the secondary market—whichever is more profitable. You cannot lose more than your initial risk (the cost of premiums to buy the options), but you can close trades very profitably.

Example

Our trader has a $100,000 portfolio and is willing to risk 1 percent of his portfolio on a trade. That current translates to a maximum loss of $1,000.

On May 1, 2018 the price of the gold trust (GLD) made a new 3-month low at a price of $123.71 per unit. This signal was a sell-side breakout.

Source: Yahoo Finance

The trader used put option to bet on the further decline in the price of GLD. He could buy an in-the-money LEAPS put option expiring January 17, 2020 with a strike price of $125 for approximately $6.70 per unit. Since options contracts are sold in blocks of 100 units, he can only purchase one contract, risking $670.

On October 23, the price of GLD hit a 3-month high—a buy-side breakout—indicating a trend reversal by this strategy, the same put option is worth approximately $9.30 per unit.

Source: Yahoo Finance

With the new 3-month high indicating the trader to sell the put option at the current price of $9.30, the trader would sell the put contract for $930. This books him a profit of $260 on the trade, or 38 percent profit on the risk he took.

LEAPS Options Spread Strategy

A spread strategy using LEAPS options can be made of the bull side (betting on a rising price) or bear side (betting on a falling price). A spread trade reduces the overall cost of the premiums for the options, potentially increasing the total exposure.

To make a spread trade, the trader will buy options at an in-the-money or near-the-money strike price and sell the same number of options at an out-of-the-money strike price. This means the trader hopes to capture profit as the price of the underlying security moves within a predetermined range.

A spread strategy effectively limits the upside potential of a trade. However, the increased exposure can more than make up for this limited upside.

In a spread strategy, the trader will still ensure their total risk on the trade does not exceed their chosen percentage of their portfolio. This means the difference in the premium paid for the long option and the premium collected for the short option will not exceed their portfolio risk level.

If the signal changes, it is important for the trader to close both positions on the spread trade! They do not want to hold a naked option going either way, exposing themselves to further risk.

However, if the covered option the trader wrote goes in-the-money and can be exercised, the trader has a few different options to reduce risk. Some options the trader could consider includes:

  1. Cover both of the options contracts and close the position; or
  2. Cover the options contract the trader sold, but hold onto the options contract the trader purchased effectively changing to a simple long-only options strategy; or
  3. Cover the options contract the trader wrote and write new options at a strike price that is further out-of-the-money.

Example

Using the same example of the sell-side trade on GLD for May 1, 2018 to October 23, 2018, the trader could place a bear spread trade using put options.

A bear spread trade would consist of two separate trades: buying a put option contract for one strike price and selling a put option contract for a lower strike price. This would cap the trader's upside, but would also lower the overall cost of the premium.

In the example of GLD used above, the trader will initiate a bear put spread 125:115 trade.

On May 1, 2018 when the price of GLD fell to a new 3-month low of $123.71 per unit, the trader purchased the same January 2020 put option for a strike at $125 for a premium of $6.70 per unit. However, this time the trader would also write a January 2020 put option at a strike of $115, collecting a premium of $3.20 per unit on that sale. The trader's net cost is $3.50 per unit.

Since the trader is willing to risk up to $1,000 total on this trade, he can double his trade size to purchase two $125 put options contracts for $1,340 and write two $115 put options contracts collecting $640. His net cost is $700, so that is his total risk exposure.

On August 2, 2018 the price of GLD fell below $115 per unit. The trader has some decisions to make based on the options above:

Option 1:  The trader will close both positions since the $115 put contracts he sold are now in-the-money and can be called by the buyer at any time.

The value of the $125 put options has increased to $10.85 per unit and the value of the $115 put options increased to $4.70 per unit.

The trader sells his two $125 contracts for a total of $2,170 and purchases back the two $115 contracts for $940. His net receipts are $1,230 for a total profit of $530. That's a 76 percent profit on his $700 initial risk.

Option 2:  The trader purchased back the $115 put options that he wrote in May for their current value of $940. He holds onto the two $125 put contracts until the signal changed, effectively changing his bet to a simple long put.

If the trader continued this trade until October 23 and sold their two $125 put contracts for $1,860, he would have booked a profit of $220 on the full trade. That's 31 percent profit on his initial $700 risk.

Option 3:  The trader buys back the two $115 put options contracts for the current value of $940. He wrote two new $110 put options contracts at $2.85 per unit and collected a premium of $570.

The price of GLD never hit $110 per unit. If the trader were to close his positions on October 23, he would sell the two $125 put contracts for $1,860 and cover the two $110 put contracts he wrote for their current value of $420.

After factoring in the cost of covering the $115 put contracts back in August, the profit on the trade would be $370. That nearly equals 53 percent of the trader's initial risk of $700.

Steps to Calculate Your Position Size Using LEAPS Options

These are the steps to identify all the components you need to complete a proper calculation of maximum position size using LEAPS options.

  1. (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
  2. (LO) Identify the current price of the in-the-money option. I highly recommend traders use in-the-money or near-the-money options to establish their position.
  3. (SO) Identify the current price of the out-of-the-money option. The out-of-the-money option pricing is only required if the trader is using a bull spread or bear spread strategy where they will be selling out-of-the-money options and collecting the premium.
  4. (P) Determine the price of the options contract.  Options are traded in contracts of 100 share blocks. The options contract price should be the price of LO or SO multiplied by 100, plus the trading cost.

The calculation for maximum position size using the Long-only LEAPS options system is as follows:

R/(LO*100) = C

C = Maximum number of full contracts to buy

or, in a single, simplified calculation:

[R/(LO*100)]*P = Total Position

The calculation for maximum position size using a LEAPS options spread strategy is as follows:

R/[(LO*100)-(SO*100)] = C

C = Maximum number of full contracts to buy and sell

or, in a single, simplified calculation:

R/[(LO*100)-(SO*100)]*P = Total Net Position

Example

This example will be a position size calculation using the more complex LEAPS options spread strategy for the iShares Russell 2000 ETF (IWM), using a 3-month breakout system.

To demonstrate how it works, we will use the entire time period of the most recent full trade for IWM. The long entry on the green line would have occurred on May 10, 2018 when the price closed at $159.53. The exit signal red line would have been on October 4, 2018 as the price closed at $163.64.

Source: Yahoo Finance

 

  1. (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
  2. (LO) Identify the current price of the in-the-money option. The nearest round number option has a strike price of $160. The price of the January 2020 IWM $160 call option was approximately $14.10 per share. Therefore LO = $14.10.
  3. (SO) Identify the current price of the out-of-the-money option. We will sell a call option with a strike price of $180, which is more than 10 percent away from the current price. The price of the January 2020 IWM 180 call option was approximately $5.60 per share. Therefore SO = $5.60.
  4. (P) Determine the price of the options contract.  Options are traded in contracts of 100 share blocks. Therefore one contract of LO = $1,410 and one contract of SO = $560.

R/[(LO*100)-(SO*100)] = C

Calculation for C: 1000/[(14.1*100)-(5.6*100)] = 1.18 contracts

C = 1 full contract for each trade

Calculation for Total Net Position: (1*$1,410)-(1*$560) = $850

The maximum net position of IWM for this trader establishing a bull call spread on May 10 will be $850.

The trader will enter a purchase order to buy 1 contract of IWM 160 option expiring January 2020 for a cost of $1,410. The trader will sell 1 contract of IWM 180 option expiring January 2020 for a premium income of $560.

During this trade period, the price of IWM did not hit $180. The initial trade was in effect the entire period. On October 4, 2018, IWM hit a 3-month low calling for an exit of the position.

In this example, the trader sold the single January 2020 IWM 160 call option contract for $1,620 on October 4. The trader then covered the single January 2020 IWM 180 call option by repurchasing it for the current price of $615.

The net sale price was $1,005 while the position cost $850 to establish. The trader realized a profit of $155, or 18 percent on their initial risk. A profitable trade!

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Risk Management: Position Sizing with Breakout Systems

This is the third method I am sharing on correctly sizing the position of each trade with proper risk management techniques. The breakout system method may be the easiest of all the position sizing calculations.

The first method is a recent volatility system which uses Average True Range as the key indicator.

The second method uses Percent Risk, either a static percent for every trade, or a percentage of the annual standard deviation of that asset.

In this post, we will explore position sizing using a breakout system method. The lookback period low will be the predetermined stop price.

Naturally, this method for position sizing and risk control pairs particularly well with a breakout box trend investing strategy.

The breakout box strategy is a simple trend investing method which has shown great results over time.

You buy an security when it makes a new high in a predetermined lookback period; you sell that security when it makes a new low in that same lookback period.

When you use a breakout box trading system, you simply move the box forward each day. When it comes to trend investing, it does not get more simple than this!

There is a growing amount of academic research into time-series momentum. We know that there is a persistent, pervasive phenomenon across asset classes where if the price of an asset makes a new high in the past 3 months to 12 months, it is likely to continue climbing for some time. Likewise, if the asset price makes a new low in the past 3 months to 12 months, it is likely to continue falling for some time.

Those time periods are not exclusive. One successful group of trend followers was rumoured to use much shorter time frames such as 20 trading days (approximately 1 month) for each market.

The chosen time frame doesn't necessarily matter if the risk control is done correctly.

By combining this research, entering an asset when it makes new highs and exiting when it makes new lows, an investor can potentially achieve outsized risk-adjusted returns.

Identifying Good Breakout Systems

Breakouts on the buy side and sell side are very easy to identify. Simply choose a lookback period that is fits your investment style based on what you want out of investing.

Generally speaking, the lookback period used should be the same across all the assets you track.

If the chosen market hits a new high within that lookback period, it is a buy side breakout. If the market hits a new low within the lookback period, it is a sell side breakout. These breakouts are your position entry and exit signals.

To develop your personal breakout system portfolio, in a disciplined way systematically track buy signals and sell signals over a long time period for a number of different asset classes you can access.

Compare the results of different timing periods and different asset classes. Performance aside, the timing period you decide to use should be one that is consistent with your personal preferences.

Generally speaking, longer time periods (such as 12 months) are likely to be much slower paced with few signals. Depending on the market, you may average less than 1 signal per year per security.

Shorter time periods (such as 3 months or less) are going to have many more signals in each market. It may not be uncommon to trade in and out of the same market several times a year in certain time periods.

A good breakout system is a system that works for your personal situation while providing a long-term positive return. It should fit your risk tolerance and your desired trading frequency.

Example Breakout Box

The price entry signal for silver (SLV) is $14.59 on February 8, 2016. That price made a new 3-month high over the previous high of $14.38.

The Stop Price on this purchase would be set at the 3-month low of $13.06.

Eight months later, silver (SLV) hit the exit signal on October 4, 2016 at $16.94 for making a new 3-month low. That's below the prior lowest price of $17.62 in the past 3 months.

Steps to Calculate Your Position Size Using Breakout Systems

These are the steps to identify all the components you need to complete a proper calculation of maximum position size using Breakout Systems.

  1. (R) Determine the maximum amount of equity you are willing to lose for each trade. This should be based on your total account equity at the time you enter the trade. (New traders should risk less than 1 percent per trade.)
  2. (P) Identify the current price of the security. I do most of my trade entries near the end of the trading day as volume tends to be higher. If you do your calculations after hours, use the closing price of the security. In this system, the current price should be a buy side breakout.
  3. (S) Identify the Stop Price. The stop price will be the lookback period low price, the potential sell side breakout. This is the lowest closing price of the security within the chosen lookback period.

The calculation for maximum position size using the Breakout System is as follows:

R/(P-S) = U (Total Number of Units)

U*P = Max Position

or, in a single, simplified calculation:

[R/(P-S)]*P = Max Position

Example

This example will be a position size calculation using the Breakout System method in silver (SLV). To demonstrate how it works, we will use the entire time period of the silver trade I shared in the example above.

  1. (R) This investor has a $100,000 investing account. His risk per trade is 1 percent. (The maximum amount of money he wants to lose if this trade goes against him is 1 percent of $100,000.) Therefore R = $1,000.
  2. (P) The breakout price of SLV on the purchase date of February 8, 2016 was $14.59. Therefore P = $14.59.
  3. (S) The Stop Price of SLV was the prior 3-month low closing price of $13.06 on December 14, 2015. Therefore S = $13.06.

R/(P-S) = U

Calculation for U: 1000/(14.59-13.06) = 653.59 units

U = 653

Calculation for Max Position: 653*$14.59 = $9,527.27

The maximum position size of SLV for this trader purchasing today will be $9,527.27, or 653 units of SLV.

The trader will enter a purchase order to buy 653 units at a limit price of $14.59 per unit. On this trade, he will allocate 9.53 percent of his account equity to SLV.

The initial stop loss price was $13.06. If the price of SLV fell below $13.06 near the close of the trading day, the trader would sell the position for a total loss of $1,000 on the trade.

Alternatively, the trader can set a Stop Limit Order and have the trade automatically executed if the price fell to this level.

In this example, the trader sold his position of SLV when it made a new 3-month low of $16.94 on October 4, 2016. The profit on this trade was $1,534.55 (less commissions). That means his profit was more than 50% higher than his initial risk of $1,000—a decent trade!

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.