Options: Answering the Leverage Question

If you trade options, you will eventually ask yourself: How many contracts should I do and for how much? That is a question about leverage and how much you want or need to own. The leverage question has to be answered properly or else you invite trade problems that can have serious consequences as well as collateral financial damage.

The mental critical path to take to effectively determine what leverage to use, and thus buy, begins with this question: What do you think is the probable move for the underlying stock over the time you choose to commit to the trade? Once you have answered that question, the one where you compute your target price over the time allotted to the trade, you then can begin to do the picking and choosing as to what calls or puts you will buy as well as the price and quantity of that buy. 

For highly risky shooter trades, I evaluate the cost of the total purchase that I choose to commit to the speculation. Once that dollar-risk question has been answered, I can then peruse the option quote tables to see where the best bang for the buck can be found. Sometimes that answer is a 10-lot of at-the-money options. Other times the answer is a 25- to maybe 100-lot or more of out-of-the-money junk (junk being very cheap options).

I never plow into any trade, especially one that could become rather large in contract size. Unless absolutely necessary, you might want to try my method, which is to average into your positions by executing three equal trades (equal, that is, in dollar size). Then rely on the probable fact that averaging into a position is far wiser than going all in, like in the way that some modern-day poker players do.

You might try to keep track of how many poker geniuses turn out to be correct by plowing into a bet in that all-in manner. It is sort of macho to do so, but this type of play is dumb. A great old floor-trading buddy of mine for many years played in the big-time poker tournaments seen on ESPN, etc. He told me he specifically hunted down (and helped eliminate) these ego-driven players, much in the same way we did in our trading pit.

If you are totally convinced that the speculation you will execute is a matter of when, not if, then what you should do is called laddering the (leveraged) position. For instance, assume you are convinced to the point where you know a stock is going up. Let's say there is a stock trading at $50 and your evaluation homework has it going to $75. The time the stock will do that is now the ultimate question for you. If you are thoroughly convinced the move is almost inevitable, you should ladder the speculation so that you will be proverbially on board when that move occurs.

Laddering the time of the move simply means you buy your options over a variety of expirations, as you do not be want to be bunched into just one expiration month (that all-in garbage again). Buying an equal number of contracts over a variety of expiries will ensure that you will catch the move that you are certain will eventually become a winner. Laddering can also be applied to the strike prices involved. That $50 stock could make that move along a steady growth path instead of one that proverbially explodes in price. Thus, laddering by strike prices to take this potential into account could become an art-of-the-trade tactic to employ.

Not to be on board for a move that you knew was most likely inevitable is far worse torture than the mind needs, as options trading does not need any additional mental daggers! I learned this personal dogma many years ago when I missed a predetermined move totally due to not allowing for enough time to have been bought in order to be on board when that move did finally come to fruition. As always, I learn plenty from my errors and hardly anything from my winners. And when I do learn something, I fix things so that never again will I be a dummy when those circumstances revisit my world. In that case, what I did those many years ago was to invent my "Five-Lot Rule"!

My Five-Lot Rule is as follows: When I have determined that the possibility for a stock move is high enough to have become a decent speculation, I buy at least five contracts (puts or calls, depending). I use highly discretionary capital for these trades. The required capital is already in a separate account, locked-and-loaded for when the Five-Lot Rule should come into play. And should that speculation not become profitable, I do not dwell on it. (Note that I define a speculation as a move having odds better than 50% -- more like 75%! -- relative to the move's potential for becoming a stock market reality.)

These are my tactics and rules of engaging leverage. You might already have your own. If not, it is wise to formulate them now as you never know when opportunity will visit. And doing so will help you become a more disciplined trader who will know what to do when the time comes!

At the time of publication, Raschke had no positions in the stocks mentioned.