Why we cap every position at the premium
Losses compound against you faster than gains compound for you. A rule that makes the worst case known at entry is the cheapest insurance there is.
By Shrey Desai
Our trading rules are short. We trade in a cash account with no margin, the most any position can lose is the premium paid, and no single position takes more than 20% of capital. The reasons come down to one uncomfortable piece of arithmetic.
The asymmetry of losses
A loss has to be recovered from a smaller base, so the gain needed to get back to where you started grows faster than the loss itself.
| Loss | Gain needed to recover |
|---|---|
| −10% | +11.1% |
| −20% | +25.0% |
| −33% | +50.0% |
| −50% | +100.0% |
| −75% | +300.0% |
Avoiding the deep losses in the bottom rows matters more than squeezing extra return out of the good trades.
Where open-ended losses come from
A sold call has no ceiling on its loss. A sold put can lose almost the full strike price. With margin, a position can also be closed for you at the worst moment, usually right after a gap. Our rule removes both problems. When you only buy options, or spreads with a defined maximum loss, the worst case is written on the trade ticket before you enter.
Sizing from the risk budget
A capped loss makes sizing simple. Decide how much of the portfolio you're willing to lose on one idea, then work backwards.
Worked example
Portfolio: $100,000. Risk budget for this idea: 2%, which is $2,000. Option price: $4.00, which is $400 per contract.
$2,000 ÷ $400 = 5 contracts
Notice what's missing: how much we like the idea. Conviction is a feeling. The risk budget is a number, and the size comes from the number.
The exit comes first
Before entering, we write down three things: the profit target, the point at which the idea is wrong, and the date by which it has to work. Bought options lose value every day through time decay, so a trade without a time stop is a slow leak. Deciding the exit in advance means the decision gets made calmly, before any money is at stake.
Educational content only, not investment advice. Figures are hypothetical. See our disclosures.
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