Option Investor

March Option Writer

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I have been meaning to write more on position sizing and allocation since I began a month ago. When I create a position for the portfolio the average position size is usually maxed out at $5000. Therefore ten positions at $5,000 equals $50,000 required to enter all ten positions. Why set it at $5,000 per position? No real reason other than being able to create a smaller position with less risk.

Position Allocation - The difficulty comes in when making assumptions about investment size and execution capabilities. Perhaps the best practice is to present the margin and return per one contract so each person can assign the amount of risk one can take. For the most part, the max margin requirement per contract will be $2,000. As you know by now I like to use higher priced stocks that require higher margins. One positive from the market's decline is that is costs less to sell options on GOOG and CME That means that theoretically you should be able to trade all ten positions with an Option Writer allocation of $15,000 or greater. Lesser allocations can apply the $1,000 - $1,500 per position rule. When choosing positions, it is important to spread out the money into various sectors concentrating on the strong ones. I know I cheat a little when using ETFs.

The hedge fund had a 20% allocation to sell option premium. Position size was generally the same across all components. However, I stepped into each trade. That means that I entered the position in thirds or halves as a way to improve average pricing. Stepping into positions is more beneficial in markets like we have now. Sometimes the positions wouldn't be the same because the level of assumed risk associated with the trade or the position moved into profitability faster than I could finish. The later is a good problem to have. Why is writing about hedge fund trade allocations and methods important? So that those of you that have signifiacnt allocations you should feel comfortable with 10 - 20 positions.

In 2001, I created a cash allocation strategy utilizing short options. The portfolio was designed so that there wouldn't be a margin call even if all of the positions were assigned. For intance, on a $1,000,000 account you sell options on 20 positions. The average position is equivalent to $50,000 if assigned. So the average position would be to sell 10 contracts of a 50 strike. The margin requirement may be about $8,000 per position. Therefore, the margin requirement would be about $160,000 leaving the other $840,000 for cash equivalents or other short term investments. Cash equivalents can be the money market, treasuries, corporates, agency bonds and municipals. If you are feeling especially aggressive, you can sell option contracts equivalent up to $100,000/position.

Return goals - My goal is to provide 8 winners for 10 trades (80% probability). That provides us with the opportunity to net on 6 trades (8 winners less 2 losers). Most of the trades are established with an initial return goal of greater than 10%. The 10% refers to the initial premium divided by the intial margin. If we hit the probability goal that should return 6% on the total investment allocation. The higher the initial return the lower the probability. Let's examine selling premium with an average of 15% return and a 60% probability. 60% yields 6 winners and 4 losers for 10 positions. The net is 2 winners. Multiply that by 15% and you get 3%. The trick is to find a balance between risk and return. I will write about allocation and risk management more really soon. Good trading.

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