Investors can put themselves at a terrible disadvantage simply by sizing their positions incorrectly. This usually occurs when their position is too big relative to the risk and account size.
The key to getting the relative sizing correctly is understanding the risks associated with the position. Let me walk you through a likely trade scenario an investor not familiar with relative sizing might make.
For example, let's say on 7/31/14 an investor looking to take advantage of a short term move... sold call spreads in UVXY. UVXY is the PROSHARES Ultra VIX Short-Term Futures ETF. It attempts to replicate, net of expenses, twice the return of the S&P 500 VIX Short-Term Futures index for a single day.
On 7/31/14, UVXY was trading at $31.70. Let's assume on that day an option investor sold 20 $36/$39 call spreads (expiring 8/8/14)... collecting a premium of $0.57 or a total $1140 (minus fees and commissions).
Their goal is to get out of the position when the premium of the spread reaches $0.29... in which they would be buying back the spread for a profit of $560.
Taking profits at 50% of the premium collected is a great level to exit... as outlined in my previous article.
The max risk on this trade at expiration is $4,860.00 (the value of the spread minus the premium collected multiplied by the number of contracts IQ Option trading India
$3 - $0.57= $2.43 x 20 = $48.60 x the multiplier of 100 shares = $4,860
However, the option investor is only willing to risk $1,000 on the position on a $50,000 portfolio. They will buy back the spread for a loss if it gets close to $1.05. On 7/31/14, the UVXY exploded... moving up more than 16% and closed at $31.70.
The investor felt that this was a good time to sell some premium as the UVXY has a history of sharp moves up followed by sharp declines.
Well, on 8/1/14, UVXY continued to climb higher as fears escalated both geopolitically and within the US equity market. It finished the day up nearly 10% and closed at $34.73. The value of the spread closed at $0.93.
Although the investor was looking at a paper loss of $720, they decided to get out of the position... if UVXY gapped up on the following Monday, it would probably get past the amount they were willing to lose.
(Note: UVXY is a product I wouldn't personally sell call spreads on... I'll explain my reason a little bit later.)
Now, when I typically short premium via structured trades... I size the trade to represent my max risk and play the odds. For example, if I were to put on this trade and was risking $1,000 on the trade... I'd sell 4 call spreads which would have a max risk of $972.
I'm not a proponent of stopping out of short premium trades.
As you know, most options expire worthless. However, there are cases where outliers occur and short premium trades go ITM and end up being losers.
By sizing my trades according to the amount I'm willing to lose... I'm not really stressed about any large overnight moves or morning gaps