Merlin’s Money Management Methods

Hey there market enthusiasts!

Merlin here.

I am back, as promised, much to the chagrin of Mrs. Merlin, who was rather keen on attending a movie this evening about a one Mr. John Paul Getty iii , which I’ve heard much about as well, and want to see. Fortunately I was able to convince her that Friday evenings are much more desirable for attending Movies. She concurred and I was grateful for that, because two nights out in a row is too much for an olde man such as myself.

Enough verbose talk of my personal life, part two of the Options Educational entries, starts now!

If you missed it, read part One here.

I wanted to talk tonight about what is probably the most important aspect of trading options: Position Sizing.

The general public, once again, understands the least about this very important aspect of options trading.

When you trade an option, it is very important that you stick to the rules of your risk management  based trading system when selecting the amount of options you are going to purchase.

It is often helpful to analyze the trade as if you were going to trade common shares and use the same level of support as your area to manage risk.

However due to the volatility of various stocks, the options may decrease in value too rapidly by the time the underlying stock has reached your stop price area on the chart, causing you to lose more of the premium payed than your predetermined risk parameters allow.

This is why I will often size the position so it is the same amount as the amount of money I would be willing to risk had I bought the common shares and placed a stop at my defined risk level.

That way if the trade works out I see a handsome gain, and if not, I lose only the amount I am allowed to risk, based on my risk management rules.

So lets say your maximum risk is $300

The stock you like is at 15 and you see a move to 20.

You could buy $15 strike options for lets say .60

You could by 5 option contracts at .60 for $300 (not accounting for fees of course)

By doing this you will have stayed within your risk tolerance parameters and positioned yourself to see gains if the stock makes your projected move as planned.

For a less volatile position, a trader can also purchase a deeper in the money call, which will see less volatility in price than an out of the money option. Deeper in the money options will not decay as much as out of the money options, but will also not increase in value like out of money options do either. This is part of a much higher level lesson we’ll have in the future about Options Greeks.

Hopefully you understood the example above and if not, please do ask questions in the comments section and I will get back to you as time allows.

Have a great evening and get some good rest, we got work to do bright and early tomorrow! Promise to be there on time.

See ya at the bell,

 

-Merlin

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