TRADING IN SMALL ACCOUNTS - RISK DEFINED TRADING
I've received countless inquires about options trading in small accounts or for those wanting to get started in options trading with a minimal amount of capital. I've built out this section to address these situations and how to effectively leverage small amounts of capital via options trading.
How can you effectively run an options-based portfolio when trading with a small account? How can you trade options on stocks like Tesla (TSLA), Ulta Beauty (ULTA), Apple (AAPL), Disney (DIS), Facebook (FB), etc., that possess such a high price per share when account balances are limited? People often shy away from options trading due to low account balances. Limited capital doesn’t preclude you from trading options and in fact you can run an effective options portfolio regardless of account size. Options enable you to leverage a minimal amount of capital which opens the door to trading virtually any stock all while defining your risk.
Myth Busting Small Account Limitations:
Options can be used in a leveraged manner hence using small amounts of capital to trade what otherwise would require much greater capital requirements. How is this possible? It’s possible because options can be traded in a risk defined manner. Therefore, entering any option trade, the required capital is equal to the maximum loss while the maximum gain is equal to the option premium income received. Since the risk-defined approach has a max loss, the required capital is equivalent to the max loss. The maximum loss value only needs to be covered by the available account balance. The aggregate price of the underlying shares within an option contract (contracts trade in 100 share blocks) is irrelevant.
The overall options-based portfolio strategy is to sell options which enable you to collect premium income in a high-probability manner while generating consistent income for steady portfolio appreciation regardless of market conditions. This is all done without predicting which way the market will move since options are a bet on where stocks won’t go, not where they will go. This options-based approach provides a margin of safety, mitigates drastic market moves and contains portfolio volatility. This strategy is agnostic to account balance and applies to accounts of all sizes.
10 Option Trading Rules for Small Accounts:
It’s noteworthy to point out that trading in small accounts does limit the amount of room for errors thus a set of trading fundamentals must be followed to successfully run an options-based portfolio. Specifically, position sizing, sector diversity, maximizing the number of trade occurrences and risk-defined strategies are some notable areas that traders need to heed for long-term successful options trading not only in small accounts but in accounts of all sizes.
In order to effectively and successfully run an options-based portfolio over the long-term, the following option trading fundamentals must be exercised in each and every trade. Violating any of these fundamentals will jeopardize this strategy and possibly negate the effectiveness of this approach on a whole. Below are 10 option trading rules for small accounts and accounts of all sizes but specifically small accounts as it pertains to risk-defined strategies when capital is limited.
Be an option seller to collect premium income while taking advantage of time decay
Set the probability of success (delta) in your favor (70%, 85%, etc.) to ensure a statistical edge
Manage winning trades by closing the trade and realizing profits early in the option lifecycle
Sell options in high IV Rank environments to extract rich premiums
Sell options on tickers that are liquid in the options market
Maximize the number of trades to allow the expected probabilities to play out
Appropriate position sizing / portfolio allocation to manage risk exposure
Sell options across tickers with ample sector diversity
Keeping an adequate amount of cash on hand (~25% - 40%)
Risk-defined trades (put spreads, call spreads and iron condors)
Risk Defined Strategy:
A credit spread is a type of option trade that risk-defines your trades and involves selling and buying an option. Let’s review a put spread as an example below.
Selling an option, you sell a put option and you agree to buy shares at an agreed upon price by an agreed upon date in exchange for premium income.
Buying an option, you buy a put option using some of the premium received from selling the option above and you now have the right to sell the shares at an agreed upon price by the same agreed upon date in exchange for paying out a small premium.
Taken together, an option spread is where you sell an option and also buy a further-out-of-the money option for downside protection. The difference in the premium received and premium paid out, is the credit spread income collected.
For example, if you sell a put option at a strike price of $46 in exchange for $85 in premium, you can use some of that premium income to buy the $42 strike put option for $35 to net $50 on the trade ($85 - $35).
In this manner, you agree to buy shares at $46, you also have the right to sell shares at $42. This will cap your losses at $350 if the stock tanks since you would be assigned at $46 and exercise your right to sell shares at $43 per share less the net premium received of $50. The $4 per share loss is the max loss you can incur and factoring in the $50 of premium income, the net loss is capped at $350. The stock can drop to $0 per share and your loss is still capped at $350 (Figure 1).
Figure 1 – Kohl’s example of a put spread generating $50 in net premium income while only requiring $350 of capital for the trade.
Maximizing Number of Trade Occurrences:
Maximizing the number trades is essential for any options-based strategy. Placing only 10 trades or 50 trades over a given time period is simply inadequate for an options-based approach. Trading through all market conditions at a specific probability of success level, given enough trades and time, the probabilities will reach their expected outcomes. This maximizes the number of shots on goal and over a long enough time period, these data will be smoothed out over the various market conditions to reach your expected probability of success. To achieve the expected probability level, hundreds of trades need to be placed and closed before the probabilities really begin to play out. As these trade data grow in size, plotting all of your trades over time, you’ll see the numbers align more and more with your expected probabilities. Taken together, trade as often as you can at your desired probability of success to achieve the win rate of interest.
Position Sizing and Sector Allocation:
Position sizing is critical and being over leveraged and assigned a losing trade can have a disproportionate negative impact on your portfolio and possibly negate all your successes. Restricting position sizing to ~5% or less of your overall portfolio will help to manage risk and contain unrealized losses. If and when positions move against you, maintaining a small position size will keep your risk profile in check. Trading across all sectors will ensure portfolio diversity and effective risk management as a result of the breath of uncorrelated stocks. Selling options across a wide array of tickers and sectors will safeguard your portfolio from any given sector downturn.
Option trading allows one to profit without predicting which way the stock will move. Option trading isn’t about whether or not the stock will move up or down, it’s about the probability of the stock not moving up or down more than a specified amount. Options allow your portfolio to generate smooth and consistent income month after month for steady portfolio appreciation. Running an option-based portfolio offers a superior risk profile relative to a stock-based portfolio while providing a statistical edge to optimize favorable trade outcomes. Option trading is a long-term game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. Put simply, an options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates. The basic building blocks of running an options-based portfolio includes appropriate position sizing, diversity of tickers (stocks and ETFs), diverse sector exposure, trading through all market environments, maximizing the number of trades, managing risk, options liquidity, taking profits early and layering in risk defined trades.
Account size does not preclude anyone from starting an options based portfolio since the required capital is minimal. Selling option spreads is a great way to leverage a minimal amount of capital and define your risk. Maximizing the number of trade occurrences, position sizing, diverse sector exposure, trading stocks and ETFs, managing winning trades and risk-defined trades is essential for an options based portfolio to succeed over the long-term regardless of account size. Options trading allow one to profit without predicting which way the stock will move allowing your portfolio to generate smooth and consistent income month after month since options are a bet on where stocks won’t go, not where they will go.
Selling options with a favorable risk profile and a high probability of success is the key. Options provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Taken together, option trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions with the probability of success in your favor.