Position sizing is a crucial aspect of successful trading, especially when it comes to vertical credit spreads. Vertical credit spreads are an options trading strategy that involves simultaneously buying and selling two options with different strike prices, but the same expiration date. The goal of this strategy is to earn a credit by selling the higher-priced option and buying the lower-priced option. Proper position sizing is essential when trading vertical credit spreads, as it can help manage risk and maximize profits.

Position Sizing Explained

To properly size a vertical credit spread, a trader must consider several factors, including the amount of capital available, the risk tolerance of the trader, and the volatility of the underlying security. One common approach is to risk no more than 2-3% of the trading account on any given trade. This ensures that a single losing trade does not wipe out a significant portion of the trading account.

Another important factor to consider is the width of the spread. The width of the spread is determined by the difference in strike prices between the option bought and the option sold. A wider spread will result in a larger credit, but also increase the risk of the trade. Conversely, a narrower spread will result in a smaller credit, but also reduce the risk of the trade. A good rule of thumb is to keep the width of the spread between 5% and 20% of the underlying security’s price.

The volatility of the underlying security is another important consideration when sizing a vertical credit spread. Higher volatility will result in higher option premiums and a larger potential credit, but also increase the risk of the trade. Conversely, lower volatility will result in lower option premiums and a smaller potential credit, but also reduce the risk of the trade. A good approach is to adjust the size of the spread based on the volatility of the underlying security. For example, a trader may increase the width of the spread when trading a high-volatility security and decrease the width of the spread when trading a low-volatility security.

My Position Sizing Rules

I like to take the complexity out of options when I put together trading rules. I am believer that you will make more money when you have simple rules. Also, it helps people who aren’t options experts understand as well. The rules I list below come from the Inner Circle Credit Spreads program.

• Low Risk Tolerance – your max loss (regardless of the width of the spread) can’t exceed 5% of your total account balance
• High Risk Tolerance – your max loss (regardless of the width of the spread) can’t exceed 10% of your total account balance

In conclusion, proper position sizing is critical when trading vertical credit spreads. You’re loses will be way larger than your wins, so a loss could massively impact your account if you don’t manage risk correctly. Traders must consider factors such as the amount of capital available, the risk tolerance of the trader, the width of the spread, and the volatility of the underlying security. By following these guidelines, traders can manage risk and maximize profits when trading vertical credit spreads.

Thanks for reading 🙂
Austin Bouley
CEO & Chief Strategy Officer