One of the most common questions we receive from viewers is "how do you size undefined risk trades?"
In an attempt to provide a solution to this question, Tom Sosnoff and Tony Battista discuss one of the best ways to truly gauge your risk in a position with a theoretical "unlimited" loss.
With defined risk trades, the margin requirement will often be the maximum loss on the trade. This makes sizing trades very straightforward. However, for undefined risk trades, we have to take additional steps to size our risk.
One of the best ways to do this is to estimate the loss at 2 standard deviations. In other words, what will the P/L for the position be if the stock moves 2 standard deviations against us? This type of move theoretically occurs only 5% of the time, so this should give us a reasonable expectation for a "worst-case" scenario.
A table is displayed that shows the 2 standard deviation risk for selling a 1 standard deviation call in AAPL. In this case, the 1 standard deviation strike is 125, while the 2 standard deviation strike is 135. Selling the call collected $0.88.
If AAPL moved to 135, our approximate loss would be (125 - 135 + $0.88), multiplied by 100, resulting in a P/L of -$912. The margin requirement for this strategy is $1,100, which covers our risk to 2 standard deviations.
If we were trading in a $100,000 portfolio and wanted to risk no more than 2% or $2,000 of our capital on selling these calls, we would be able to sell two contracts since our 2 standard deviation loss would be approximately -$1,824, which is within our $2,000 loss threshold. The losses could be larger than this, but 95% of the time this will give us a reasonable estimation of our risk.
As we always say, it's crucial to stay small, but this is especially true when trading undefined risk strategies!
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