Position sizing for premium sellers

Discussion in 'Options' started by hlpsg, Jul 23, 2008.

  1. hlpsg


    What kind of position sizing methods do (time) premium sellers here use? By premium sellers I mean you trade things like credit spreads, iron condors, calendars, etc.

    How long have you used this method, and how successful has it been for your trading?

    Two methods I've come across that may be applicable to premium sellers, are the fixed risk method, and the Kelly Formula. I've also read the book on Fixed Ratio and tried to model it on my past trades, but I think it's too risky, as I think it makes me trade far too many contracts.

    I'm currently leaning towards risking a fixed % of total portfolio per trade.

    Let's say I risk 3% per trade, but I have 3-4 possible trades I could take, what is a reasonable cap on market exposure at any one time, assuming my trades are diversified into non-correlated instruments?

    Althought the instruments are not highly correlated, I'm aware that doesn't mean they can't all take a loss at the same time. So for this reason, how much of your capital will you put at risk, at any one time?

    Lastly, besides Van Tharp's book, is there any other *good* resource that covers money management, aka position sizing, in detail and at length?

  2. Mine is not entirely scientific but has worked well. I always scale in to my trades and I only sell Naked Calls during or right after a big move up towards resistance.

    With that said, I sell about 2% of account size and scale into it in 1% increments up to about 4-5% of account size. Then I throw in a maximum of 1% on Naked puts.

    I rarely let my position expire worthless so I don't get the entire 4-5% premium. I usually leave about 1% on the table.
  3. MGJ


    When selling naked options, or when selling option combinations that get you short the wings, one possible scenario to consider is a very large price gap against your position. If you use "distance to my stop price" to calculate "risk", remember that the underlying can gap waaaay beyond your stop, giving you a much bigger loss than your "risk" calculations had forseen.

    If you sell a 120 strike call for 4 with a stop at 10, remember that the underlying could gap to 200, so your stop order to exit the position would be filled at approx 80 rather than at your stop price of 10. You thought your "risk" was 6 (10 - 4), but in reality you lost 76. Ouch.

    Some people deal with this unpleasant reality by never selling naked options (never being short the wings). They sell spreads and combos which are either neutral, or long, the wings.

    Other people deal with this unpleasant reality by putting their fingers into their ears and marching into the minefield. "It can't happen to me" is their battlecry.

    Still other people deal with this unpleasant reality by calculating their "risk" using a "conservative" estimate of the worst scenario that is "remotely possible" to happen in their trading lifetime. They do a calculation something like this:
    • I'm only going to trade for 20 years or so
    • I'm going to make 1000 option-selling trades per year, at most
    • So I'm going to make at most 20,000 option selling trades before I quit trading
    • Assume that for position size calculation, I select a "risk" so the probability of a price gap beyond my "risk" point, is 0.5E-6 (two million to one odds)
    • Then the probability that I will have 20,000 trades in a row that don't gap beyond my risk point, is (1 - 0.5E-6)^20000 = 0.99
    • So there is a 99% chance that none of my 20,000 lifetime option trades ever have a loss beyond my "risk" point
    • Now I get out my trusty probability tables and turn (odds of two million to one) into standard deviations
    • The tables say that (two million to one) odds correspond to a move of 4.9 standard deviations
    • So for position size calculations on each of my option trades, I'm going to use a move of 4.9 standard deviations as my definition of "risk". This gives me a 99% chance of surviving my entire trading lifetime with no fatal price gaps.
    And so forth
  4. cdowis


    Position sizing for me:

    1. Do I know what I am doing? Is my strategy working? If I am uncertain about my option trading strategy, I use small positions until I have confidence in my system.

    2. What is the market doing? I use calendars, so I use smaller positions in medium to higher IV environments.
  5. drcha


    Position sizing on market neutral strategies should be looked at with reference to your entire portfolio.

    Keep in mind that if 1987 happens again (and this year was just a slow-mo version of it--I'm talking about a huge move in one day or overnight) it will wipe out every condor/fly that you have on. Always keep in mind that you can lose every penny of your margin. Stops and position adjustment plans will not help you in such a situation.

    Keeping an insurance policy in place by keeping some long options around will be of some benefit, but one can't afford too much hedging, otherwise there would be no profits. Having long vega, market neutral stratgies is not a good enough hedge--those will get wiped out, too, due to movement of the underlying.

    Best thing to do is to imagine a total one-day tsunami, and ask yourself how much your account could be down before you could do anything about it. The amount that will allow you to go to sleep that night determines your position sizing. Then divide that number by the number of trades you think you can manage, and you have your position size.

    Does it make sense?