The question was asked from last week’s commentary, “How can we maintain a constant risk factor when trading options?”  Let’s once again assume that our constant risk factor is 2% of the capital invested of 16K per trade or $320.

We first determine the stop loss amount.  I checked the Qs at about 8:30 MDT today (Friday) and the Qs were trading at $37.41.  If we place our stop at the low of the prior day, the stop would be $36.72.  Our stop margin is the difference between where the stock is currently trading and our stop loss.  The resulting amount is $.69.  If we are going long and decide to BTO the ATM August long call, we would first confirm the current delta (which was .57)  That means that the theoretical change in the 37 strike August call for every $1 move in the stock would be $.57. 

Whereas:

SP = Stock Price, SL= Stop Loss, RC= Risk Constant, SM = Stop Margin, D = Delta, ALPO = Allowed Loss Per Option, C = Contracts Purchased

The formula and math is as follows to keep our risk constant at $320:

(A)    SP-SL = SM x D + ALPO

37.41 – 36.72 = .69 x .57 = .39

 (B)  RC / (ALPO x 100) = C

               320 / (.39 x 100) = 8

The proof is as follows:

Cost of the 37 August call is 1.31.  C x cost of the call = invested capital.

      8 contracts x ALPO = RC

      800 x .39 = 312- 320 (accounting for rounding factors)

We can now be assured that we can BTO 8 contracts on the Qs with the expectation of a bullish move in the ETF, but with the knowledge that if the stock doesn’t perform as anticipated, we will be stopped out at a stipulated loss of $320.  You can set a contingency sell stop with your broker to close the option position when the stock trades at the stop loss level of $36.72.   The stop triggers a sell order on the option and you are out with a $320 loss.   

Remember that stops are not guaranteed.  The market can blow through stops.  However, you have a much better chance of being stopped out at your stop level when trading highly liquid, diversified ETFs like the Qs.  Best, Robin

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