How to size one’s options trade is a subject that is certainly open to much debate. However, for traders looking to use options as an alternative to stock, you’re in luck. I have a simple way to think about how many calls to buy to balance leverage and risk.
Let’s say stock is trading at $100. That means it will cost you $10,000 to trade 100 shares.
The 50-day $95 call* is trading at $7.00.
Instead of trading 100 shares of the stock, buy 1 call for $700 and leave the rest of the capital ($9,300) in cash. We’re going to assume the stock reaches $110 per share at expiration. The stock position is worth $11,000 for a $1,000 (10%) return on capital.
The option is worth $1,500, which with the $9,300 in cash, adds up to $10,800, an 8% return. When one call is substituted for every 100 stock shares, the limited risk to the call ensures that the option position plus cash cannot make more money than owning the stock.
However, bump up the number of calls purchased and things change quickly. Increasing the position to three calls costs $2,100, leaving only $7,900 in cash. Again, let’s assume the stock reaches to $110 and the stock position earns the same 10%.
However, the calls are now worth a total of $4,500 ($1,500 x 3). With the $7,900 in cash, results in $12,400 or a 24% return. If the stock reaches $115 (+15%), the value of the option trade rises to $13,900 or a 39% return. If the stock is $100 or less at expiration, you’re left with only 79% of the starting capital. The stock would have to go down to $79 for the option trade to do better.
Get the picture? The more capital you allocate to the options position the more leverage you get. In other words, a higher return on the same capital in exchange for the greater loss if you do not get the move you expect.
*The reasons for selecting the in-the-money $95 call is a subject for another post.