Keep Risk in Check
by Bryan Perry 03/18/09
It's important to be mindful when it comes to how much leverage you can wield by implementing a single options trade, because a small investment can go a long way. A single options contract controls 100 shares of the underlying stock, and just because an option seems inexpensive, it's not prudent to buy options contracts in excess just because they seem like a bargain.
The amount of risk you carry increases when you investing in higher-priced options. We love options because you can control the underlying stocks for just pennies a share. But when you're investing in options that cost more than what you're accustomed to spending, keep in mind that an option trading for $1.80 (for example) is three times as expensive as a 60-cent option.
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While we know you understand the math, it's crucial when it comes to preserving your capital to designate a figure that you feel comfortable investing in each trade -- and then remain consistent so that you're not making big bets that can turn into big losses if you can't check on your trading account for a period of time.
If you would normally buy 20 contracts of a 60-cent option (a $1,200 investment), then the appropriate number of options to buy on a $1.80 option is one-third of that, or seven contracts (a $1,260 investment).
If you're comfortable risking $1,200 per trade, then try to stay in that range with each trade, no matter how much the individual contracts cost. That way, if something happens and the trade doesn't go your way, you're OK with losing the $1,200 you typically risk and not, say, $3,600, which is what it would cost to buy your "usual" 20 contracts of the more-expensive option.
Remember, it takes a bigger-percentage move for that 60-cent option to make a nice-sized return, so a bigger number of contracts can give you the added leverage you need to turn a significant profit. The $1.80 option needs less of a big move to have you performing a victory dance. So, by investing commensurately, you're investing wisely.
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