October 10, 2003

Money Management Vol. I:
How much money should you trade?
By John Brasher, CallWriter Publisher

 

No trading-related subject is more important than money management, since it concerns protecting your money by active risk management. And nothing is more central to money management than the questions of how much money should you trade in the first place, and how much money should you allocate per trade. This article presents some plain-sense ideas on the amount of money covered call investing requires and the extent to which you can and should diversify into multiple trades.

Introduction

Covered call writing is an income generation trading strategy, not an investing strategy. While it is possible to write calls on stocks that are long-term investments, and many do this (including large mutual funds), I consider covered writing to be trading. Part of money management is deciding whether to trade at all, and if so how much money to trade. Since I am not an investor, I will not speak to how much of any portfolio should be invested in stocks for the medium or long term.

I'm not an expert on the subject of how much money anyone should invest or trade, how to allocate trading capital among different trades, nor even whether any particular individual should be trading at all. Frankly, I'm not sure anyone really is an expert, except as to themselves. Numerous books and innumerable articles have been written on the subject, as well as the psychology of investing. The thoughts that follow are presented to help traders assess what their buying power requirements are to run covered call trades, based upon our common-sense observations about covered call investing. In the final analysis, you and only you can make the most informed and rational decision about your money, precisely because it is your mind, your experience, your fears and preconceptions, your tolerance for risk, and your money.

That's why the purpose of this article is not to tell you how much of your net worth you should invest, nor whether you should -for example - mortgage property to obtain trading capital (I'm not in favor of that), nor whether you should be trading in the first place. Since I am not an investment adviser, and don't want to be, it is my duty to urge you to consult with your investment adviser or financial consultant. Brokers, by the way, are not investment advisers nor trained as such, and the input they can give you is very limited under the law, so they tend to duck these questions. But be forewarned: while you are free to consult with anyone on earth, the answers to these questions can only come from you.

Covered Call Basics

Since this article is about covered call trading, before diving into money management let's be sure we're talking apples and apples. A covered call trade is a combination transaction that had two legs: one is the sale of call options and the other is the purchase of the underlying stock in order to "cover" the calls. That is, once you sell call options you will be obligated to deliver the underlying shares of stock if the calls are exercised. By purchasing the underlying shares of stock at the time of selling the calls, the shares "cover" your delivery obligation in the event you are called out. If you sold call options without owning the underlying stock, the calls would be naked. This kind of covered call frequently is referred to as a "buy-write"; because you buy the stock and write the calls. Writing calls against stock you already own is called an overwrite. It is common to discuss covered call contracts in terms of the number of call contracts sold. One who already owns the stock can of course write calls against it to generate an income.

Suppose we decided to write a covered call on XYZ Corporation (XYZ). We buy the stock at $24 and write the current month's 25 Call for a $1.00 premium. Because we buy the stock at $24 and collect a $1.00 in premium, the net cost per share (net debit) is $23. The trade looks like this:

The net debit on the trade is the stock price paid less the call premium received. We really should add trade costs in, as we do below, but this essentially is the net debit on a covered call trade:

A standard stock option contract is for the sale or purchase of 100 shares, so you generally must buy 100 shares of the underlying stock in order to cover a call contract. Thus covered call trades usually must be run in round lots. Writing 4 covered call contracts, for example, would require you to buy 400 shares of stock to cover the calls sold (4 x 100). There are exceptions to the rule that an option contract is 100 shares; these are known as non-standard contracts and they occur due to reverse splits and other corporate reorganizations, but the vast majority of option contracts relate to the standard 100 shares.

Example:  A covered call trade involving 4 contracts (4 x 100 = 400 shares) would be referrred to as a 4-contract trade. If the underlying stock cost $10 and you wrote 4 call contracts against it, you would need $4,000 ($10 x 4 contracts x 100 shares per contract), less the premium amount received for the calls sold.

Covered Call buying power requirements are dictated primarily by:

1. The price of the underlying stock,
2. The premium per share received, and
3. The number of call contracts written (number of shares bought)

It takes four times as much buying power to write covered calls on a $40 stock as a $10 stock. The number of contracts written has the same effect, since it takes four times as much buying power to write 4 contracts as 1 contract, since you must buy 4 times as many shares to cover the calls..

Buying Power - How Much Money You Need

First, let's get straight the concept of buying power. The inputs to figure the buying power needed for any trade are very simple:

The net stock price is simply the stock price less the premium received from writing the calls, plus the commissions. Suppose we decide to write the current month 25 Call for a $1.00 premium on XYZ Corporation (XYZ) when XYZ is trading at $24, and that our commission cost to run the trade will be $30 total. We decide to write 5 contracts, which would require us to buy 500 shares of XYZ. Here is the buying power needed:

We simply took the $24 stock price, subtracted the $1.00 in premium we expect to receive and added back the commission cost. The commission cost is easy to figure. The total commission cost is $30. Writing just one contract would spread the commission cost over just 100 shares, and the cost to run the trade would be $0.30 per share ($30 ÷ 100). But since we want to write 5 contracts, this lowers our commission cost per share to just $0.06 ($30 ÷ 500), because the $30 in commission is spread over 500 shares. If you don't want to bother calculating trading costs, just use the net debit on the trade of stock price less call premium. You should care about trade costs, of course, which are covered in more detail in my Money Management II article.

This makes it sound a lot like a complicated formula, but it isn't. They're just simple money inputs - your money. To figure actual costs, and actual returns, you have to take commissions into account.

Margin. Available margin (which is a loan from your stock broker to buy securities) will increase your buying power, up to double - the most margin the law allows. That is, the law will allow the broker to loan you a maximum of half the stock's cost. Margin increases your buying power, but its use also increases your risk. Margin is not good or bad, of course, but in using margin the rule is to never get your exposure too high. If you have $50,000 in cash in an account, your broker might let you buy $100,000 of stock, but that doesn't mean you should take on that much exposure.

In this article I'm speaking in terms of available buying power instead of available cash with which to trade. If a trader uses margin then buying power includes margin. If a trader had $7,000 in cash in an account and the broker extended $2,500 in margin, then the trader would have $9,500 in buying power available. If if a trader doesn't use margin, then buying power is simply the actual cash available.

Note: You can only run margin trades in a margin account. Your account statement typically will tell you how much margin buying power is available to you. Stocks in a margin account can be loaned to others by your broker under margin rules (if they are unencumbered), for which the broker charges a fee; you receive the interest on the margin loan. A cash account does not permit margin trades.

Writing One Covered Call Trade at at Time

Assuming that you want to write a single covered call trade on one stock, Example 1illustrates the buying power requirements for stocks at different price levels of $10, $18 and $35. There is nothing magical about these stock prices; they are just to help you develop a feel for how much buying power trading will require.

You see below that writing 4 covered call contracts on an $18 stock would require $7,200; that same $7,200 in buying power obviously would allow you to write 8 covered call contracts on a $9 stock. Continuing this example, an allocation of $5,000 buying power per trade would permit the trader to write 2 covered call contracts on that $18 stock ($3,600 is needed), but would be insufficient to write 3 contracts, because $5,400 in buying power would be needed. Yet the same $5,000 allocation per trade would handily allow a 4-contract trade in the $10 stock.

In the above table, the buying power requirement just to run one trade varies considerably, from $1,000 to run a 1-contract trade in a $10 stock to $14,000 to run a 4-contract trade in a $35 stock. Consider the price of any stock you are considering writing as a covered call, and you can make your own table of buying power needed.

The table above DOES NOT take premium or commission into account. We are just looking at the maximum possible number of dollars needed to run the trade, in order to get a sense of the amount of money required. The premium collected would of course reduce the amount of cash needed to run the trades.

One Trade or Diversify into Multiple Trades?

However much buying power you have available and have decided to use, the first question is whether your buying power should go into one or into multiple trades simultaneously. Traders with larger buying power seldom want to run just one trade at a time; they prefer to be in multiple trades simultaneously in order both to put their full buying power to use and to reduce their exposure to any one trade. All things being equal, the ideal money management strategy is to diversify your buying power so that you don't have an undue concentration of risk in any one trade.

Suppose instead that a trader wants to have 3 covered call trades in place simultaneously on different $18 stocks in a single month, the buying power requirements would be as illustrated in Example 2:

As Example 2 shows, a trader would need $1,800 to $7,200 just to run a single covered call trade in an $18 stock (Column D). For a trader to have 3 separate covered call trades open simultaneously in different stocks all priced at $18 would require from $5,400 to $21,600 in cash (Column F), depending on how many contracts were written.

Regarding the above two examples, we understand that the premium received will slightly increase your buying power. But for illustration purposes, we kept the math simple in the first two examples by ignoring trading costs and any call premiums received. The next example will squarely address trading costs.

Trading Commissions

The bane of all non-professional traders is commission cost. There is a lot of confusion among inexperienced traders as to how commissions are structured and charged. So here is the straight skinny. A covered call trade is actually two trade orders (or legs): a purchase of stock and sale of call options, and you pay a commission for each. If you are called out of the stock, or aren't called out but sell the stock after option expiration, you must pay another commission to sell the stock (but no charge to you when the holder exercises the calls). And if you are forced to close the position, you must buy back the call options and sell the stock, which involves another two commissions. To summarize:

• Enter trade = two commissions
• Sell stock = three commissions in total
• Close trade = four commissions in total

Let's look at how this works in Example 3, using the optionsXpress.com commission structure of $14.95 minimum for an option trade (up to 10 contracts) and $14.95 minimum for a stock trade:

So you will pay $29.90 in commissions to enter the trade, and another $14.95 if you are called out (or if the calls expire worthless and you have to sell the stock), for total commissions of approximately $45. If instead of just selling the stock you must close repurchasing the calls and selling the stock, your commission total is approximately $60. So your best case for trading commissions to exit a position is $45. And these commissions are the same whether you write one contract or 10!

Whatever the actual cost, commissions all have one thing in common: the more contracts you write, the lower the cost per share. Obviously, trading costs make a difference, and more to the point, the number of contracts you write makes a huge difference. (Note that in the above table, to open and unwind a covered call trade you would normally never have to pay commissions A, B and C; you would pay either A and B or A and C, but not all three.)

How Much Cash Should You Trade?

I think it makes good sense to take part of one's savings and dedicate it to trading, to generating income far beyond what is obtainable from savings accounts, money market funds, Treasuries and the like. The question is what percentage? In deciding how much cash to allocate to trading, you must consider your unique circumstances. Those circumstances include cash available for trading, whether or not you want to use available margin to increase buying power, trading experience, risk tolerance, whether you are trading money you can't afford to lose, and other foreseeable cash needs in your life, among many other possible considerations.

Guess what: the experts don't always agree on these matters, either. But there is one trading canard on which every writer to our knowledge agrees: don't trade with money you cannot afford to lose. There is an old Wall Street saying that "scared money never wins." This means that people trading money they can't afford to lose make poor decisions and tend to lose all discipline when things go wrong.

The following example featuring two traders with very different personal circumstances highlights the difficulty in advising anyone how much to invest.

Example: Two traders with $20,000 accounts (total buying power) each could have greatly different personal circumstances. For example, one might be an experienced trader, be very liquid and the $20,000 might be small in relation to his cash on hand and net worth. The other trader might have little trading experience, might not be liquid at all and might have mortgaged his or her house to the hilt to get the $20,000 to trade.

Will their risk tolerance be the same? I doubt it, since one trader is investing money he can't afford to lose. Should they be equally comfortable using margin? Again, I doubt it, since the illiquid trader needs trading experience and confidence right now more than he needs the additional trading leverage that margin offers (and the correspondingly greater trading risk that margin entails).

This isn't very helpful, I realize, but there is no one-size-fits-all formula for deciding how much to trade or invest. If you want to invest long-term as well as trade, then you have to allocate cash between the two goals.

Example: Two couples each have $50,000 in savings, equity in a home, pension or 401K plans and roughly the same net earnings. Yet one couple are DINKS (double income, no kids), and the wife is diabetic. They are greatly concerned about her future health and possible medical expenses. The other couple is healthy but has three children in college, one headed for medical school. Their needs and future needs are quite different.

If we all planned for every possible future need, we would never have money to trade. On the other hand, perhaps the question is this: would you prefer to grow your money at a glacial pace or bring in a vastly higher income through rational trading? I don't think leaving large amounts of money in a money market fund earning a few percent annually is conservative at all. It makes much more sense to me to make money with our money. But in the end, how much money to trade - in fact, whether to trade - has to be your choice.

How to Allocate Buying Power Per Trade?

Once you've decided to trade, and how much to trade, the next question becomes how much to diversify. Many money management gurus believe that you should never put more than 5% to 10% of your buying power at risk in a single trade, in order to reduce the risk of any particular trade hurting you badly. Putting too many eggs in one basket concentrates your trade risk in one or a few trades. There is no doubt that this is sage advice. If your buying power is sufficient to let you have several different positions open simultaneously, then this advice is sterling.

But consider: if your total buying power is relatively, say, $5,000, then observing this guideline would effectively prohibit you from writing covered calls at all, since allocating even 10% ($500) to each trade would provide only enough buying power run 1 covered call contract in a stock $5 or under, and even low commission costs would guarantee a loss on the trade even in almost every case! So the person with a smaller account faces a Hobbesian choice: observe the classic money-management guidelines to limit single-trade risk, or put all or most of the buying power into one trade or a few trades.

Suppose a trader has $25,000 in an account with which to trade. To keep it simple, this trader will not use margin. To minimize the impact of trading costs, the trader decides to run at least 3 contracts per trade. How might this trading deck be allocated? The table below assumes

In this example, our trader was able to put his entire $25,000 account to work and diversify into 4 separate trades, at least 3 contracts per trade. But notice that there are no pricey stocks there, no stocks over $30. In fact, running the intended minimum 3 contracts in a $60 stock would have used up $18,000 of the account, leaving just $7,000 available for a second trade. Would the trader have been better off to run 10 contracts (1,000 shares) in a $25 stock in which he was extremely confident than to diversify as shown above?

My answer is that if the trader liked and had confidence in the above trades, the diversification is better than putting all the eggs into one basket, even though running 10 contracts of a single trade greatly reduces trade costs per share. But suppose the account was much smaller, say $7,500?

The trader in Example 5 found a way to diversify into 3 separate trades within his $7,500 account. But these under-$10 stocks can be very volatile. Would the trader have done better to find that more stable $25 stock and run 3 contracts in it rather than diversifying into 3 trades?

In my opinion, the answer is: choose the best stocks you can afford and truly are willing to own. If that includes $6 and $8 stocks you have analyzed and like, then feel free to write them. My point is: never diversify just for the sake of being diversified. Running bad trades in cheap stocks just to diversify is a poor trading choice.

Faced with this choice because of small account size, I personally would almost always opt to run multiple contracts in the same stock rather than splitting the buying power and running one contract each in multiple stocks. The reason is that running multiple contracts in the same stock lowers your costs per contract, and I'm confident in my ability to pick winning covered call trades and minimize losses. In other words, I am willing to accept the "concentration risk" of putting more money into a single trade if it cuts trading costs per contract, because cutting the trade costs increases profitability, and in my view more profit amply offsets the risk of not being diversified into more positions. Trading is about winning, and if commission costs eat up your profits, what is the point of trading, anyhow?

In the final analysis, there is only so much buying power for any trader to work with, no matter how large or small. It's all about managing your money and deciding where to put it. I hope this article is helpful to you in deciding on your own money management strategy.

Good luck and good trading!