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, here’s a simple way to think about how many calls to buy to balance leverage and risk.
A stock is trading at $100. It will cost you $10,000 to trade 100 shares.
The 50-day $95 call* is trading at $7.00.
Consider the following:
Instead of trading 100 shares of the stock, buy 1 call for $700 and leave the rest of the capital, $9,300, in cash. 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 1 call is substituted for each 100 shares of stock, 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 3 calls costs $2,100, leaving only $7,900 in cash. Again, take the stock to $110. The stock position earns the same 10%. The calls, however, are now worth a total of $4,500 ($1,500 x 3), which with the $7,900 in cash, results in $12,400, a 24% return. If the stock reaches $115 (+15%), the value of the option trade rises to $13,900, a 39% return. But 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, i.e. a higher return on the same capital, in exchange for the greater loss if you do not get the move you expect. Choose wisely.
*The reasons for selecting the in-the-money $95 call is a subject for another post.
