In today's video, I want to talk about the smart use of leverage when it comes to trading options. The whole idea here is that we just want to be conservative with our use of capital because options are very, very powerful, but they can also cause us to make really bad decisions if we’re not smart about how we use and allocate our capital.
As we know, options trading offer us the unique ability to leverage our capital and probably one of the easiest ways to leverage capital in the markets.
And rather than buying let’s say 100 shares of stock for $50 which would cost $5,000 upfront, we could buy a simple option for $500 and control or gain access or leverage to 100 shares of that same stock. We use $500 versus $5,000 just to drive home the point here.
This is a look at Citigroup and Citigroup right now is trading at about $50, about $50.5 right now is where Citigroup is trading and we could go in here, and we could buy the underlying shares, buy 100 shares of this stock and that would cost us a little over $5,000.
So about $5,053 to buy the actual stock or what we could do instead is we could go out to the March options which are about 66 days away, and we could buy a deep in the money call option at a 47 strike which we’ll get to later on, just breaking down all of these different things.
But we could buy that option for about $510. You can see that we use a lot less capital and we still have about the same type of profit potential in this trade.
Not to say that this is any better or worse of a trade that we like to make because we don't do single long options, but it just proves the point of how you can use and leverage options in your account and how you can control a lot more shares of stock with less money.
The downside of using leverage is obviously that you can increase the amount of risk that you have exponentially in your account because just as much as we can increase our return exponentially on every dollar that we invest, that also works in the other direction.
I wanted to present this table to you that shows how much you would need to create or generate in return to recover from losses if you over-leverage your account.
What we suggest here at Option Alpha is a sliding scale approach to allocation between 1% and 5% of your account per trade and that is going to be different based on your account size, so you can go ahead and look at all of the trading guides and allocation guides that we have inside the membership area.
But this just gives you a frame of reference as to how over-allocating on any single trade or any single set of trades can be detrimental to your account.
As you can see here, we start with a $10,000 balance. If you were to lose 25% of your account which leaves you with about $7,500 which is honestly not something that is not uncommon…
We see this a lot with new traders who start, is that they come to us and they say, “I had $10,000. I lost about $2,500.” Because you can get into a couple of trades that are a couple of hundred dollars and lose your shirt on this and it’s very easy to lose $2,500 in this business trading the wrong way.
But what’s important here is that you don’t just make $25 to get back to par. Now you’re starting with $7,500. To get back to that $10,000 account balance that you started with, just to recover from where you were, you need to generate 33% on your new balance.
As soon as you lose 25%, you have to generate 33% on your new balance to get back to square one. This is also why I hate other newsletters that are out there that have a 25% losing month, and then they come around, and they say they have a 30% winning month and now they’re up 5% on the year, and they do this calculation.
But it’s not a simple addition. You don't just lose 25%, make 25% and you’re back to square one. It just doesn't work like that, and a lot of people out there are obviously presenting false information.
The same thing works as we work down this list. You can see $10,000 if you lose half of your account, you got to make it up by almost 100%, so you got to have a 100% return on your investment to just get back to par.
And then the most alarming one is $10,000 allocating and losing 90%, and you’re left with $1,000. You’ve got to make up 9,000% of your new balance just to get back to where you were, to begin with. This is not uncommon.
I see this all the time when I start coaching people, is that they come to me and they say, “I started with some amount, and I lost, and it just seems like I can never get my footing back.” And that’s because you allocated too much, to begin with. You should never have losses that are 50%, 75%, 90% of your account balance at all.
If you’re trading small and trading smart as we’ll show you in the other video tutorials and courses that we have here at Option Alpha, there’s no way that you can blow up your account if you’re doing it the right way, impossible to blow up your account if you're doing things the right way and trading small and on the right side of volatility.
As you get started with options trading, understanding the options can be very powerful in generating higher returns, but you need to be smart about how you do it.
I encourage everyone to go to optionalpha.com, sign up for our membership because you can download our position sizing PDF which goes through all of the different position sizes that you should have based on different percentages and your account size, so it optimizes the best of both worlds.
It’s a very quick PDF that you can use and post in your desk, and it gives you great access to position sizing, so you don’t have to think about it when you’re entering a trade. As always, if you guys have any questions or comments, please add them right below in the video lesson page. Happy trading!