Determine the typical move per day. Divide volatility by 16 ( 16 is the sqrt of 256 trading days). 20%HV / 16 = 1.25% move for the day. Determine your primary greek exposures. Model the change in greeks from that probable move. That will give you the probable pnl change you can tolerate/risk for the day. Of course, there may be foreseeable and unforeseeable events that may be forewarned by IV. Size accordingly. If you have a consistent strategy and want to double your money as fast as possible, I would recommend a Kelly sizing calculator. But, be careful using Kelly on short option strategies.
Could you please give an example of how to use the above to size a position in options - based on a stop located on the underlying stock's chart -? Thx
I was graciously corrected by a true options SME via PM. To quote Sinclair: "traders often think that 16 percent annualized volatility corresponds to a daily return of 1 percent. but this is due to confusing the square root of average squared returns with the daily return. to translate between daily return size and annualized volatility we need to divide the volatility by 20." so 20 HV implies 1 percent move a day, instead of 1.25%. naturally, multiplying the daily return by 20 gives a quick and dirty estimate of annualized volatility.
I could try to salvage my credibility in a future time or sell a put option for "Foot in mouth" . I choose the latter. Ok. If you have a predetermined stop from the chart. I assume you trading a method based on price action. Let's say you want to short IBM down that triple bottom of 173...also known as the price that Warren Buffet started buying IBM. It has recovered in early June and may be heading down further. We would typically set stops at 188 which just happen to be previously established top( resistance). Normally, your sizing algorithm for shorting the underlying is 100 shares. You select 185 June21 put option ATM, it only has a delta of .50. That's only half the exposure. so I buy 2 185 puts which comes close to the max exposure you allow yourself when trading the underlying. What happened to the 188 stop? It is almost immaterial because your 185 puts will have gone to zero before that 188 is reached. Why not 187.50? You can use that, but then I would need a calculator. Seriously, strike selection is another question deserving it's own thread. The puts you purchased have positive Gamma. So the more you puts go in the money, the more deltas you pick up. These are the corresponding deltas and $deltas for this position at varying prices. Note this is doubled (2 lots) Stock Delta $Delta 185 106 $19,537 180 165 $28,756 175 195 $34,056 The point that I'm making is that your exposure can change radically with a simple directional exposure. That's highlighting convexity risk. So maybe you'll decide to put on less risk at the start of the trade or maybe you'll say your ready to assume that risk when you get there. We haven't even factored in the duration risks in your exposure by the rate of decline in option price over time(Theta) and changes in implied volatility (Vega). Other strategies will raise the impact of these risks, but they are almost always present in all strategies.