3 Step Formula To Easily Figure Out How Many Options Contracts You Can Trade

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It's fairly easy to blow up your trading account. . .

Too often, traders (both advanced and beginner) allocate way too much to a single trade.

They think that because they have a "smaller" account that they need to up the risk and leverage to make money "faster".

What a stupid mentality. . .and I want to show you how to figure easily out how to calculate your appropriate contract size.

And lucky for you it's only three steps.

Step 1: Determine Your % Risk Per Trade

In my options, this is the best way to manage risk size and the number of contracts. Historically called fixed fractional risk.

For example, you might risk 2% of your account equity on each trade. If you have an account of $50,000, this would mean that no more than $1,000 of risk ($50,000 X 2%) would be allowed per trade.

Personally, I wouldn't go any higher than 5-7% per trade even if you are just starting out!

If you cannot learn to trade small positions profitably from the beginning then how will you ever learn to trade a larger account later on?

Sure commissions have an effect on your trading, but you can factor them in according to your situation.

Step 2: Determine Your $ Risk/Contract

The next part is to take the individual trade you are looking at and determine what the max risk is for that trade or strategy.

If you are trading a long Call/Put, this would be your premium paid. For vertical spreads, it's the difference in the strike prices less the credit received.

For example, you are trading a SPY 175/170 Put Spread and take in a credit of $100. The difference in strikes is 5 points or $500 less your credit of $100, so the max risk is $400 per spread.

This is the one lot spread risk per the contract we'll need below. . .

Step 3: Divide % Trade Allocation by $ Risk/Contract

With both of the figures from above we simply divide the max percentage allocation per trade from #1 by the risk per contract from #2.

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$1,000 max risk per trade / $400 max risk per contract = 2.5 contracts

Easy right!? Now you know that based on your portfolio and risk tolerance you can trade at most 2.5 vertical spreads on SPY.

You can round up or down as you wish, but at least you have a better guideline to use instead of guessing.

Next Steps. . .

Managing this key aspect of risk can make all the difference in the world in your ability to trade options for income each month.

Remember this is just 1 example using a Vertical Put Spread. If you have questions about how to calculate your risk per contract on other strategies like Iron Condors, just add them to the comment section below.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.