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Position Sizing by PJ Scardino

The purpose of any trading system is to:  Minimize risk  Maximize reward  & not let your emotions get in the way

Money Management or how to control risk  Position Sizing determines how much you can win or lose on any given trade.  Use Reward to Risk (RR) ratios to maximize your gains  This is the 1 st step to having a successful trading system!

RR Example:  Your risk is $1 your expected gain is $3 then Reward vs Risk = 3 to 1 also shown as 3:1 or just RR=3  Note: Given RR=3 and if your win 4 out of 10 trades then overall return is 20% It’s also 20% if RR = 2 and wins = 6 out of 10

Defining Risk  Know your exit targets before you enter the trade (stop loss & profit objective)  You buy a stock for $20 your stop is $15 Your objective is $30  Then the potential Reward is $10 & the potential Risk is $5. RR = 2

How can we do this with options?  You could just set the stop and profit objectives on the option or …  Using your favorite tool (Technical, Fundamental, Sentiment, or Ouigi board) Define stop and profit price points for the stock and calculate the option prices for the stock at those levels.  Then compute RR for each option you are interested in. Here’s an example …

QCOM 12/31/03 eSignal Advanced Chart Wave 5 top, confirmed by Oscillator divergence. Minimum retracement target identified by Ellipse. Price objective is previous Wave 4.

QCOM 12/31/03 OptionVue Chart The blue outline in the upper right corner is the projected price and time.

QCOM analysis  We expect the price to fall and fill the gap left at (roughly in the area of the previous wave 4)  If price exceeds then our current analysis is wrong.  At a minimum price should retrace to the ellipse at (which is also the middle of the Bollinger Band)  This should happen in the next 2-6 weeks

Options Matrix for QCOM 12/31/03

Which Option would you buy? Here’s what Trade Finder came up with: Capital provided is $5000.

$5000 not our real risk!  Worst case the stock reaches our stop and we exit the option position. $54.90 in 39 days  Maximum gain occurs if the stock reaches the target price in the minimum number of days. $46.10 in 13 days  Minimum gain occurs if the stock reaches the minimum price in the maximum number of days. $52.80 in 39 days

Risk graph for Feb 50 put (39 days) Stock =$55 Option =.20Stock =$52 Option =.60

Risk graph for Feb 50 put (13 days) Stock =$46 Option = 4.80

 Initial price of Feb 50 put = 1.35  If we reach our stop in 39 days Stock = then Feb 50 put =.20 Risk = ( ) = 1.15  Note that if only the minimum target of is reached the option is only worth.60 which would actually be a loss not a profit!  If we reach our target in 13 days Stock = the Feb 50 put = 4.80 Reward = ( ) = $3.45 RR = 3

Position Size  If we are going to risk $5000 we will buy 43 contracts at $1.35 ( the risk per contract is $1.15 )  This would require $5805 of capital (not including commissions)  We are actually risking 86% of the capital

Questions to answer:  Does the contract have enough liquidity?  Is the capital requirement too large?  Is this the best RR we can get?  What about an OTM option or a contract with more time?

QCOM Apr 55 put

Position Size for Apr 55  We can buy the Apr 55 put for $4.60  The risk per contract is $1.30  We can risk $5000 but let’s say we only have $10,000 of capital available so …  All we can buy is 22 contracts making our risk just $2860  Note: we are only risking 28% of the capital!

An Excel worksheet will do much of the work.

Account Info  1 st step is to enter your account info  Row 2 establishes the max risk as 5% of the account  Row 4 insures the size of the trade does not exceed available cash or a 10 % of account Fields in Blue can be changed by the user

Step 2: The Option info  After entering the option as month, strike and expire -- the symbol will be created and if you have eSignal the current price will be calculated  For each option enter the value for Stop Min Target Max Target  Enter Target Range in E11:F12

The Results:  RR and Pos Sz are displayed for each option.  Also shown are values for Risk, Reward, Gain, Actual Cost, OI (open Interest) and Volume  Observe the Feb/Apr 60 puts have the highest RR but  The red S and V indicate an open interest / volume alert  The Apr 55 put has RR=3.9 and enough OI and volume

Any Questions? If you would like a copy of the presentation or the Excel spreadsheet send an to: If you would like a copy of the presentation or the Excel spreadsheet send an to: Give me the courage to pull the trigger when the market has changed; Give me the strength to hold my ground when it hasn’t; And give me the wisdom to know the difference!

SMH – Semi hldrs

Follow-up on QCOM, SMH 1/7 QCOM stop triggered, Apr 55p at 3.80 loss =.80 1/8 SMH target reached. Jan 40c gain of 1.85