Position Sizing Ideas for Naked Short Options

Sean McLaughlin
April 9, 2024

When putting on positions with undefined risk (naked short puts, or short strangles, for example), one question I often get asked is: “How do you determine your position size?”

This is perhaps the most important question to ask when putting on these types of trades!

I have two imprecise, imperfect ways that I decide:

The first method is a quick-and-dirty, non-optimized, and usually more aggressive method.

I’ll target a trade-entry credit that I want to collect upfront based on a percentage of my trading capital. Generally speaking, I want to collect 1%.

If I have a $100k account, I’m looking to collect approximately $1,000 of net credit for the short put or short strangle trade (equal amount of short out-of-the-money calls and puts) I’m initiating. However many contracts I need to trade to earn that dollar amount is my targeted position size.

It is important to note that I only use this method when trading indexes or sector ETFs. These products have less of a probability of a sudden overnight gap moving against me, making risk management problematic.

The second, often more conservative method I employ relates to the cost of a long stock position should I get assigned against my short puts. For example, if the position I’m considering involves short puts at a strike price of $50, then that means I could potentially be assigned stock at a cost of $5,000 (100 shares times $50/share) per contract I hold short.

I don’t want the cost of any potentially assigned stock to cost more than 10% of my account value. So, using numbers from above, for a $100K account I wouldn’t want to be on the hook to purchase more than $10,000 worth of stock. If I’m shorting $50-strike puts, this means I’d short two contracts.

If I got assigned against these two short put contracts, this means I’d pay $10,000 in my assignment of 200 shares of stock. In the unlikely event that the stock goes to zero before I have a chance to exit my position, the worst hit my entire portfolio would take would be a 10% hit. That sucks. But I can recover from that.

And recovering from losses is how we succeed in this game.

Whether I employ the first method or the second, whenever I’m in doubt, I’ll always trade smaller. It’s just good, common sense. These trades are never designed to be home-run profits, so I certainly shouldn’t allow them to take me out of the game!

Trade 'em Well,

Sean McLaughlin
Chief Options Strategist
All Star Charts, Technical Analysis Research

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