Sizing your Options positions

Sizing your Options positions


A user recently asked us, If there was an easy way to determine how many options contracts she should sell given an account's size and an expected annual return?

I know from experience that given an Options strategy I employ, I need to sell around $3,000 in Option Premium for every $1,000 of the final P&L I intend to keep. That is a P&L of roughly 30% of the premium received.

But how did I get to that rule of the thumb?  Bear with me.

Set Your Revenue Target

First, set your revenue goal—for example, 15% of total assets. For an account of $100,000, if my target is 15%, I should get around 15,000 per year.

That is 1,250 revenue per month. 

Run the Backtests:

Run a backtest of the strategy you are going to utilize.

In my case, I am selling a naked Put at 20 Delta, 45 days to expiration (45 DTE). I close the positions if it hits 50% of the maximum profit or losses to 3 times the premium received.

Run the test over ten years or more. Get your results on a spreadsheet and obtain:

- Total premium received
- Total Gains
- Total Loss
- Resulting P&L: Gains- Loss
- Get the ratio: P&L / Total Premium received

Repeat for each of the symbols you are planning to use.

For example, I use two sets of underlying:

  1. Market ETFs: SPY,QQQ,IWM
  2. Tech Stocks: AAPL, AMZN, NFLX, MSFT, ROKU


The average ratio for: 

- ETFs is 28%
- Tech stocks: 41%

If you sold PUTs on SPY over the lasts ten years, you were able to keep 28% off that premium and total profits.

Apply the Backtest Ratio to your Current Target

Assume that going forward; the market keeps the same behavior.

If I sell 10,000 worth of premium using the above strategy, I should expect to keep $2,800 (or 28%).

My target is to have an average P/L of $1,250 with Options from the whole group of stocks and ETFs.



For example, today, the SPY Put close to 45 days to expiration (45 DTE) sells for $4.35.

So, to hit my target, I should sell two contracts @ $4.35 total premium received: $870, a bit more than our $774 mark but within the correct range.

Repeat the same operation for the rest of the symbols until you get to your premium target of $3,756. 

You can use this technique with other strategies and other symbols, backtesting each of them to find their own  "P&L to Premium Received" ratio.


Takeaways

If you use your backtest to calculate the "Premium Received" target, it is then straightforward to get the right size of your options contract position. 

You may want to rotate both the strategies and the symbols you use for every cycle based on other factors such as the implied volatility, your current portfolio, the available liquidity, your market awareness, and bias. But the basis for sizing in each cycle can be the same.

Keep selling that premium month after month, and you should be on your way to obtain the returns you expect from your account.