Leverage and the Use of Options

One of the most misused statements I have ever heard is “effective use of capital”. Not that it isn’t important in trading and investing to make wise and effective use of your capital… it’s just that I hear a lot of folks say “effective use of capital” in a VERY wrong context.

Usually that context is the notion that buying in-the-money calls as a substitute for stock is some really great idea. SO great that you should “make effective use” of ALL off your capital to buy in the money calls.

Now, some folks reading this are bound to say, “well, shoot… I never said put ALL of your money into in-the-money calls… just a limited percent.” But you know what? That isn’t what a lot of folks have been taught. It certainly isn’t what a lot of folks practice, or at least from where I’m sitting it isn’t.

I’m counseling a gentleman right now about a number of in-the-money IWM LEAP options that he got into in September 2008. What do you figger HE has to say now about “effective use of capital”? Ouch. Poor fella fell for the siren call of “conserving capital” when it should have been called, “risky as using margin”.

It’s amazing how much teaching is out there about HOW to trade, and how little there is about HOW MUCH. Effective position sizing is the most important part of any trading strategy, and yet the gurus (most of ’em, anyway) fail to mention it. Many that do still give position sizing rules a back seat to technical indicators, fundamental analysis, and options strategies.

Don’t think that size matters? Anyone that says that is compensating for SOMETHING…. 😉

Okay. Quit grinning and let’s face facts. If you were to say to your sweetheart, “HEY, Honey… I just made 100% in one of my trades”… what will be the question that inevitably must be answered? “That’s wonderful, darling! HOW MUCH did you have in that particular trade?

Makes a difference, doesn’t it?

On the other hand, say one of your stocks gapped down by 30% overnight, and the call option you were holding on that company is down by 50%? Ouch… unless, of course, the 50% that you lost is a DOLLAR amount that represents only 1/2% of your total trading capital.

Sure. You can do that, can’t ya? If you have $100K to invest and buy one call option for $10 ($1000 per contract), and that contract goes down to a value of $500… you have lost half of one percent.

I’m going on record here to say that the dollar amount you have AT RISK in any one trade oughta be about 1%. MAXIMUM 2%.

Now, you can accomplish setting that risk a number of ways, including using stop orders and strict trading rules… but there haas to be something to this fact:

ALL the most successful traders in the world practice a form of money management that puts 1% AT RISK in any one position. We’re talking commodities, currencies, stocks, etc.

YEAH, you can get more “leverage” by risking a greater amount. And SURE, your return will be much more respectable when you’re right and were swinging a bigger line.

But the fact is, you’ll have strings of losers as well as strings of winners. And just as you begin to develop a habit that’s being rewarded by the winning trades…

That habit of risking too much is going to really hurt when a trade (or SEVERAL) finally goes against you. Believe me… or believe my clients that formerly got sucked into highly leveraged trading.

The single most important factor in trading happens to also be the only one over which we have any control. HOW MUCH to risk in any one position is the least understood and yet most easily handled and controlled component of trading.

In my next article, I’ll give some tried and true money management strategies that have worked for traders all over the globe, myself included. Thanks for reading!