The Beginner’s Guide To Capital Allocation & Position Sizing (For Options Trading)

One of the common questions that I often get is on capital allocation and position sizing when trading Options.

And it’s no surprise because capital allocation and position sizing are crucial to long-term profitability.

If you have a profitable strategy but you do not allocate your capital efficiently, then your returns will be dismal.

And more importantly, even if you have a profitable strategy but your position sizing for your trades is too big, then you could end up blowing your account on a single trade.

So how do you properly allocate your capital and position size your trades when trading Options?

Capital Allocation Rule of Thumb

In general, we do not want to risk more than 5 to 7 percent of our capital on any single trade.

So for example, if you have a $10,000 trading account, then 5 to 7 percent would mean that you can only allocate a maximum of $500 to $700 to any trade.

For example, let’s say you put on a 5-point wide Bull Put Spread and the BPR (Buying Power Reduction) is $350.

That means that the maximum loss for the trade is $350.

Since you’re able to allocate $500 to $700 per trade, you’re able to trade a maximum of two Bull Put Spreads.

In the event that you lose the maximum loss on this trade, your loss would not exceed $700.

That also means that the maximum loss would only be 7 percent of your trading account.

It still leaves you enough capital to fight back and become profitable in the long term.

If you have a bigger trading account (i.e. $100,000 and more), then you can reduce the capital allocation to 1 to 3 percent per trade.

That’s because, with a bigger trading account, you’re able to put on the same positions as a smaller trading account, while risking a smaller percentage of your capital.

This way you can put on more trades and diversify your risk better.

Capital Allocation On Undefined Risk Trades

The Bull Put Spread is considered a Defined Risk trade.

That means that the BPR would be the maximum you can lose.

However, this is very different for Undefined Risk trades (i.e. Strangle, Short Put, Put Ratio Spread).

That means the BPR shown for Undefined Risk trade doesn’t indicate the maximum possible loss.

For example, if you sell a Put Option on Starbucks at the strike price of 70, the BPR only shows $776.65.

This is the capital you need to put up for the trade.

However, the maximum loss is $6,855.

So how do you allocate your capital in this case?

The answer is that you still allocate your capital according to the BPR, however, you will have to manage your trade.

Unlike Defined Risk trades, you can hold your trade to expiration, and the maximum loss is still contained to the BPR.

With Undefined Risk trade, you must avoid holding your trades to expiration, because that’s when huge losses (greater than the BPR) can incur.

So when we are trading Undefined Risk trades, we want to manage your trades at the 21 DTE mark.

Why the 21 DTE mark?

That’s because when you manage your trades at the 21 DTE mark, there’s only a very small chance of the loss exceeding the BPR.

And if you trade the Index ETFS (i.e. GLD, SPY, XLE), there’s a 0 percent chance of your loss exceeding the initial BPR for the trade.

That means to say that as long as you manage your Undefined Risk trades at the 21 DTE mark, your maximum loss will be contained within the BPR.

Position Sizing Your Option Trades

Position sizing is linked to your capital allocation.

While capital allocation depicts how much risk you can allocate per trade, position sizing depicts how many Option contracts you can trade.

So here are a few questions to see how well you’ve understood capital allocation and position sizing so far.

Let’s say you have a $50,000 trading account and you’ve determined that your maximum risk per trade is 5 percent of your capital.

Then let’s say you want to put on a Bear Call Spread that has a BPR of $700.

For this trade, how many Bear Call Spreads can you sell?

The answer is that you can trade a maximum of 3 Bear Call Spreads.

Here’s how you calculate the position sizing for this trade.

First of all, you need to determine what is the maximum dollar risk for the trade based on your capital allocation.

Since your maximum risk is 5 percent of your capital, that equates to $2,500.

Next, you take $2,500 divided by the BPR of the trade.

That means $2,500 divided by $700, which equates to around 3.57.

Since we don’t want to exceed the maximum potential loss of 5 percent on our capital, the most we can sell is 3 contracts of the Bear Call Spread.

Now, what about Undefined Risk trades?

Position Sizing For Undefined Risk Trades

Position Sizing for Undefined Risk trades is similar, except that you will have to make some leeway for the BPR.

For this, let’s use the trade example of the Short Put on Starbucks, as shown above.

Before you put on this trade, the most important thing to take note of here is that Starbucks is an individual stock (as opposed to the Index ETFs).

And from the table earlier, we know that individual stocks tend to be much more volatile than Index ETFs.

That means to say that even if we manage our trade at 21 DTE, there’s still the chance that the trade can exceed the BPR.

So how do we position size our trades in this case?

First of all, we know that our maximum risk for this trade is $2,500.

That means, as much as possible, we want to contain our maximum potential loss to just $2,500.

Next, we know that the BPR is $776.65 per Short Put.

If we were to just allocate our capital based on this number, we’d be able to trade 3 Short Puts at most.

However, there’s a chance that the maximum loss can exceed $776.65, even if we manage our trade at 21 DTE.

Also, because this is an Undefined Risk trade, the BPR can expand if the market crashes.

Therefore, we need to take into consideration these two very important facts.

So the first step is to consider a larger BPR for this trade.

That means that instead of using the $776.65 BPR as indicated for this trade, we can assume a $1,000 BPR for this trade.

This way we give some room for the BPR to fluctuate in case of a large adverse move in the stock, and also have a higher chance of the maximum potential loss being contained to this BPR.

The second step is to have a hard mental stop at the $1,000 maximum loss mark.

That means that as long as the loss of each Short Put reaches -$1,000, we immediately close out the trade.

This way we limit the maximum loss and not let any single trade wipe out our account.

So by considering a BPR of $1,000 for each Short Put, it means we can trade at most two Short Puts for this trade.

This way, we’re able to manage your downside more efficiently, at the same time position size our trades enough that we also generate a decent return when we’re profitable.