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Ask The Analyst, Sunday, 06/20/2004

Position Size is up to you
By Jeff Bailey

When reviewing your "open position profiles" it appears you and I invest the same on your "stock Profiles", $10K/position. I am curious, if you don't mind sharing, how you decide your investment in the option positions. I see no pattern in your updates.

Due to a prolonged power outage, I'm re-printing an e-mail question I received earlier this week, and what ended up being a rather lengthy e-mail response.

Great question, and this is how I was taught to think about options.

I'm using $10,000.00 as a base number. Some investors that may be managing their own money may feel comfortable with 10 positions at $1,000.00 per STOCK position. Some investors may feel comfortable with 10 positions at $50,000.00 per STOCK position.

OK... now think of this.

What does 1 option contract represent? 100 shares right? Right!

OK... now... REGARDLESS of what security we are looking to trade BULLISH or BEARISH this is where OPTIONS mitigate RISK and how I was taught to treat an option.

How many shares of a $100 stock could you buy with $10,000 (if this is what you would invest in the UNDERLYING STOCK?) 100 shares right? Right! OK.... how many contracts do I buy to represent 100 shares? 1 contract right? RIGHT!

How many shares of a $20 stock could you buy with $10,000? 500 shares right? How many contracts? Five.

OK....

For YOU Frank, it sounds like a "full position" is $10,000.00 per UNDERLYING STOCK trade.

But what about Sue Subscriber and her $50,000.00 per UNDERLYING STOCK investment, or John Subscriber and his $1,000.00 per UNDERLYING STOCK trade?

Now do you see the pattern?

Jeff Bailey's Market Monitor OPEN Profiles - 06/18/04 Close

Take the Stillwater Mining (SWC) October 15 Call profiles. 2 separate profiles, for 1/2 each (2 * 1/2 = 1 full position).

(Note: Pink arrows are the actual profiles. Only the IPIX was profiled with the underlying stock as this security does not trade with options.)

OK... on 05/27/04, stock looks like it is going to break out (but I'm a bit uncertain as to what the dollar may be doing) so I profile 1/2 position just in case SWC rockets higher to challenge recent 52-week highs.

If $10,000.00 in UNDERLYING is full position, then a 1/2 position is $5,000.00.

So... SWC UNDERLYING stock is trading $15.60. I quickly take $5,000.00 and divide by $15.60 and get... 320.51 shares. Boom! That's 3 contracts.

Next.... What's my risk to a point and figure sell signal?

SWC would give a sell signal if it were to trade $12.00.

What's my RISK in the UNDERLYING STOCK to that sell signal? From $15.60, I calculate $3.60 per share RISK. Hey.... I'm mitigating my risk with the OPTION at $2.90 per share/contract. Not only that, but EVEN IF SWC trades $12.00, where I would probably have to STOP OUT on the STOCK, I've ALREADY assessed that RISK with the option, but now I've got until OCTOBER to let the stock work toward where I think its is going.

Look at the PnF chart of SWC at this link . Now... a STOCK trader that was LONG/BULLISH SWC may have gotten stopped out back in February (after the red 2) when the stock did give a sell signal at $11.00. OK, so be it.

However.... let's say YOU as an OPTIONS trader that had bought the June $12.5 calls when SWC was trading $14.00, and paid $3.00 per contract, would YOU have stopped out of the OPTION when SWC traded $11.00? I'm not sure what the options would have done, but if they were down 50% at the time, would it have made sense to stop out with a loss, after ALREADY having assessed $3.00 per share risk before I/you put the trade on?

(Note: Friday was option expiration for June contracts. If still holding June $12.50 calls, we have the RIGHT, but not the OBLIGATION to buy the stock at $12.50 per share, or we can close out that June $12.50 call option for $2.70.)

With a bullish vertical count of $32.00 associated with the PnF chart, if a trader did NOT over leverage in June $12.50 calls, I would exercise the call option, and take possession of the underlying stock. I could perhaps write covered call on part of the position if 700 shares ($10,000 / $14 = 714 share equivalent). Here, do you see how if I over leveraged back in February at $14 and bought 20 option contracts, I may have had to either stop out of the option (bit off more than I could chew) and perhaps my account discipline says I can't buy 2,000 shares at $12.50?

Some option traders do use stops, but I think it is mistake!

Why do I think its is a mistake to trade stops on options?

BECAUSE... if you DON'T over leverage in OPTIONS, and if you use the discipline of establishing a consistent TRADE SIZE based on what you would invest in the UNDERLYING STOCK, then in essence, when you pull the trigger to buy an option (put or call) then you've basically consigned the loss, or RISK and once you've done that, then all that is left to worry about when to take PROFITS if they're had.

I'm no different than most when it comes to losses. I hate them. But it makes me SICK to my STOMACH when I see options traders put on a trade, take a 50% loss in their option by stopping out 2 day's later, and then 2 weeks later, find the stock/option now PROFITABLE as the trade works in the DIRECTION of their analysis.

Now... Look at the EBAY Put. Here I did got outside of the $10,000.00 divide by $78.48 per share, thus 127 shares, and did "round up" from 1 contract to 2 contracts. Here perhaps I look at a $3.10 per contract and say.... "$310.00? Get two of them." Hindsight being 20/20, at this point 1 put contract looks like it would have been too many. TIME will tell with one month left until expiration.

Now... Look at the DIA Puts. Certainly $10,000 of a $99.36 security would have a full position being 1 contract. So... for $0.65, or and additional $65.00 I round to full position (have I really gone overboard with this one? An extra $65.00?). If I see both the DIA falling to $101 anytime soon, and get the option trade "break-even" (between the two) then I'm closing out both with July expiration now just a month away. However, the ONLY way I have a shot at break-even is to have RISKED an additional $65.00. Might not be worth it, but it might be.

Now... IPIX Corp. (IPIX) .... this is a stock that has been showing up as being very volatile, but has been garnering both BULLISH and BEARISH trader's interest in recent months. If I were managing/investing/trading a $100,000.00 base account, would I (Jeff Bailey) put $10,000 of my own money in this stock at $14.30 with a stop at $10.50, representing a potential 26.5% loss? I (Jeff Bailey) would not. However, we've traded IPIX more than a couple of times on a day trade basis, and it has been rather clear that this stock will fluctuate $1 or $2 (sometimes more) in a day.

OK Frank... this e-mail was long. Now, here's a more detailed thought process you might also want to review.

The FIRST article I wrote for the Ask the Analyst column on 11/17/2002 (look under Education, then Ask the Analyst) describes in greater detail something I think EVERY trader or INVESTOR should do BEFORE they open an investment/trading account.

The articles title is "Your account is your business," and may give investors/trader some insight as to establishing a business plan for their account investment/trading strategy.

Let me know what you think....

Jeff Bailey

 

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