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. Here is a simple formula to determine how many options contracts you should trade.
I want to show you how to easily figure out how to calculate your appropriate contract size. Managing this key aspect of risk can make all the difference in the world in your ability to trade options for income each month.
And lucky for you, it's only three steps.
Step #1: Determine Your % Risk Per Trade
For me, 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!
If you cannot learn to trade small positions profitably from the beginning, how will you ever learn to trade a larger account?
Sure, commissions have an effect on your trading, but you can factor them in based on your situation.
Step 2: Determine Your $ Risk/Contract
Next, 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, if 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.
$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.