A bit on position sizing for options selling

If you are following me on twitter, you would already know that I pay a lot of emphasis on position sizing and I believe it to be the single most important thing to be kept in mind if you are selling options. It doesn’t matter what trading style you have — whether you are buying options or selling options, follow a trend or play mean reversion — position sizing is important for all of it. However, in case of option selling it is even more important because of the tail risk associated with option selling. One should not blow up their entire capital and go out of business in case of any black swan event. In this blog, I will try to put some thoughts together on how you should arrive at an appropriate position size for your account if you are selling options. If you are already selling options or are looking to get into option selling in future, I hope this serves as a good primer.

Let’s start with some basics -

Margin — Simply put, margin is the amount required to put up a trade. Let’s say Reliance trades at Rs. 2000 and you buy 10 shares for delivery, then the margin required for this trade in a normal account will be Rs. 20000. This is full margin. However, say you want to take this trade intraday only and the broker offers you margin benefits for intraday trade, then you are allowed to take this trade with only a certain fraction of total underlying value. For example the above trade, the broker might ask you to pay Rs. 5000 in your account to put up this trade. Similarly, in margin accounts (in the US), only a small amount is required for margin (even for delivery trades) and not the full value of the underlying.

Leverage — Both margin and leverage look very similar to each other but there is a slight difference between the two. Leverage can be expressed in terms of ratio. In the above example, we got margin benefit and were asked to pay only Rs. 5000 for the underlying value of 20,000 so in this case our leverage becomes 4:1.

Notional Value — Notional value (or exposure) of any position is the total amount of risk for that position. In the above example, if we have taken 10 shares of Reliance for 2000 bucks each, then the notional value for this trade is Rs. 20000 because if the stock goes to 0, we stand to lose the entire 20000 and thus same is our notional exposure of the trade. The broker provided us margin benefits for the intraday trade and although we took the position with only 5000 in our account but we will lose 20k if the share goes to 0. It works in a similar fashion for options too.

Example 1 — Reliance is trading at 2000 bucks and you decide to short the 1800 put for 20 Rs. Then the notional exposure for this trade is the amount that one would lose if the stock goes to 0 which comes out to be — Strike price minus the Premium, times the contract size i.e. (1800–20)*505 or 9 lakhs approx.

Example 2 -If one sells a straddle or an OTM strangle, then, the notional exposure is underlying price times the contract size or 2000*505 or ~10 lakhs. This is so because only one side will get tested in case of straddle/strangle and not both. Although the notional exposure in case of a strangle is somewhat less than that of a straddle based on the strangle strikes but for simplicity let’s calculate it based on underlying price times the contract size.

Position sizing for an INR 20L account

Having understood the basics (and most of you might already know that), let’s now talk about position sizing. I know a lot of people selling options are doing it with an account size as low as 5L but I believe 20L is the minimum capital one should have if looking to sell options. The simple reason is if the account size is decent enough (20L or more) it will allow for enough positions/diversification to avoid the tail risk. There are two ways one can manage risk — either deploy risk defined strategies or deploy undefined risk strategies but keep position size low. I have always been doing it the second way and I am still sticking to it even after the new margin benefits rules. More than 80% of my positions are undefined risk and very rarely do I deploy risk defined strategies like ironfly, iron condors or vertical spreads. For undefined risk trading style (options selling) it becomes even more important to have enough capital in your account to not only have different diversified positions but also for adjustments that you might need to do. In a 5L account, you will only be able to take one position, which would mean higher tail risk and no room for maneuvering.

There is also a misconception among many traders that by availing margin benefits, one can increase position size and deploy full capital since the positions are risk defined. After all, it’s only as much that you can lose. Here’s a TastyTrade episode on risk defined vs undefined risk strategies which should give you some perspective on both of these and the respective position sizing.

Undefined-Risk vs Defined-Risk — From Theory To Practice — tastytrade | a real financial network

Let’s see how it will work for a 20L capital with risk defined strategy. Assume one takes ironfly and shorts the ATM straddle (0.5 delta) with wings at 0.1 delta and deploys 15L or 75% capital on this strategy then with the given position below one could take 20 lots and the max loss as 3L but the cushion is not even 2% move in the underlying. Of course, with some adjustments, one could get the loss down but even then if the underlying makes trending moves for a few weeks then there is a lot of capital erosion that would happen. The position was hedged/risk defined but was that really a not-so-risky position? Even if one is deploying risk defined positions, it’s important to have low position size as it won’t be wise to lose as much capital on a single trade even without a black swan event or a fierce move in underlying.

Suggested Method — Like I have said earlier, I deploy naked option strategies and manage my risk by keeping position size in check. Position sizing should be determined based on notional exposure. A conservative trader should not take more than 1.5 to 2X exposure. A moderate risk taker can take anywhere between 2X to 3X exposure. That’s what I do, most of the time I will carry positions with 2 to 2.5X exposure and occasionally I carry upto 3X exposure when the going is really good. Don’t try to be a “Superman in catching someone else” and take more than 3X exposure as that’s surely asking for trouble. You can undoubtedly make a lot of money by taking more exposure but you never know when will the next black swan event happen. So, always assume that it is going to be tomorrow, everything opens at circuit filter tomorrow and ask yourself are you prepared for it. In such a case, how much one loses will determine if they will stay in the game long enough. With about 2.5X exposure and good adjustment methods, the loss should be contained within 15–20% of capital, which although a lot is still acceptable in case of a shock event. A quick and dirty way to figure if you are right in your position size is by looking at your unutilized funds. With all naked option strategies, if you have more than 40% of funds unutilized, then all’s good. Obviously, it’s one’s personal choice to deploy the kind of strategies they want but taking cues from one of the TastyTrade videos, here is my take on the strategies one can deploy on a 20L account — 1 lot SSO straddle, 3 lots SSO strangles, 1 lot naked put short and (optionally) 1 lot naked call short. This should be about 2X exposure.

The kid with the right position size.

Notes -

1. This is based on what I do i.e. delta neutral option selling in SSO. If that’s not what you do, then it might not be applicable as is. Obviously, the underlying idea remains the same in any case.
2. I am not against risk defined strategies but one should understand that they should not increase position size just because the position is risk defined and with new margin benefits, one can deploy more. At the same time, I am not advising anyone to take undefined risk strategies. It’s what I do and it has been working very well for me for the past few years. With a lot of hard work, discipline and loads of luck, I have been able to make 3% pm on average and I am very happy with it. .
3. If starting out in options selling, be conservative and take only 1.5X exposure. Safety first. As you grow confidence, you can always slowly increase the exposure up to 3X.
4. Try to diversify in stocks. Have positions in stocks from multiple sectors.
5. Trade more, trade often!! Don’t stick to the same set of stocks month on month (I used to do that earlier but not anymore). I keep switching stocks based on the underlying vol regime.
6. Don’t sit on losing trades and hope for reversal, make active adjustments as and when needed.
7. Not all trades will be winners and there will always be losers, so don’t lose more than 2% of your capital on any trade unless of course there is a huge gap opening the next day.
8. Don’t get mesmerized by big fat MTMs and target returns in X. Start with capital protection, try for 1–2% monthly and take it on from there.
9. And if there is only one take away from this post that you should take — it should be doing yourself the favour of keeping risk and position sizing in your mind — all the time.

I had written a piece on alternate approach to trading breakouts through options selling, you can read it here in case you are interested.

Also, a word of thanks. I am a self made trader and have always placed a lot of importance to self learning. While there are a lot of freely available resources a particular one that I want to mention is TastyTrade. Some gratitude and love for them.