One of the most common questions we receive here at Investitute is in regards to Ron’s Risk Calculation (RRC). This was first described in our 2nd newsletter, but we feel that is important enough to repost here in the BLOG.
How Much Money Should You Spend on Your Option Position?
One of the first and most important questions an option trader or investor is going to ask is how much money should be spent in an option position versus a stock position. Keeping in mind an options advantage of mathematical leverage, you should be able to spend less money in the option position than you would have to spend in an equivalent stock position. That is obviously a very nice advantage but there is actually a better way of calculating how much money to spend in your option position. I call it Ron’s Risk Calculation and you will soon see why it is becoming such a popular technique for calculating how much money you should spend in an option position!
The beauty of Ron’s Risk Calculation (from here on referred to as RRC) is that it not only addresses the concept of funding but also addresses the all-important concept of risk management. So, let’s get into what RRC is and the benefits of using it.
When trying to decide how much money to invest in options, one MUST take into consideration the amount of leverage you get from options. Now, before getting panicked over the word “leverage,” understand that the type of leverage you receive from options is good leverage … that is to say mathematical leverage. It is not the leverage received from borrowing money! That is the type of leverage that got this market into a lot of trouble in 2008 and 2009 in the Financial Crisis.
With that said, options would allow you to do one of two things. You can get a much bigger position with the same amount of money or you can get the same sized position with much LESS money! Obviously, your broker and Wall Street would like you to employ definition number one … same money and bigger position. However, it is definition number two which is the one we want. By using less money to have the same sized position, we enacted a solid risk management plan from the get go.
The conventional way to do this (called the Conventional Risk Calculation) is to simply buy the amount of contracts that represents the amount of shares you would buy or sell. For instance, if you thought a stock was going to go up and you decided to buy some calls, you should first think about how many shares of stock you were going to buy. If you would have bought 500 shares, then you would buy 5 calls. If you would have bought 1000 shares, then you would buy 10 calls. This is because each contract is worth 100 shares of stock. The formula would simply be to take the amount of shares you would have normally purchased and divide it by 100.
Although a good way to control the SIZE of your position by controlling your expenditure, it does not necessarily control your risk in the manner that RRC does. RRC is calculated in a different way with a different concept in mind … not size but RISK! First, figure out at what price you would purchase the stock. Then, figure out where you would naturally set your stop. This would create a total amount of dollar loss per share that you would accept. Then, times that by the amount of shares you would have purchased. This will give you a total net amount of money that you would be willing to risk.
For example, say you were going to buy ABC stock at $100 per share. Once purchased, you set a stop order of $90. This basically says that you are willing to lose $10 per share but no more in trying to take advantage of this potential opportunity. Now, if you would have bought 1000 shares and you are willing to risk $10 per share then you are willing to lose $10,000 but no more. That $10,000 is the amount of money that you should spend on buying your options.
The beautiful thing about the RRC is the risk management factor. If you bought the stock and put in a stop order, there is NO guarantee that you would only lose $10,000 maximum. As we all know, stop orders do not work when the stop gaps against you! You could still possibly lose much more! However, if you use the $10,000 (the amount you were originally willing to lose based on stock price, stop price, and total shares to buy) to buy the calls then you can lose only that $10,000 and not a penny more no matter what happens to the stock! Now that right there is a solid start to any risk management program!
RRC works extremely well in shorter term trades due to the much smaller amount of money used in the investment and the much higher option prices out over time. We do not recommend using it in any trade beyond about 2 months out. However, it is amazingly effective and offers incredible flexibility allowing traders a gigantic advantage in short term trading over the Conventional Risk Calculation.