The internet, specifically FinTwit, is full of charlatans and snake oil salesmen telling you that their magical tricks will get you to your wildest dreams. The reality is most are average at best and don't espouse any real tangible knowledge or give you an edge. So it is because of this, and because when markets get rocky my inbox blows up, that I wanted to take a moment and give my personal insight on the most common question I get asked.

As someone who has been trading transparently for three years now I often hear the same questions. No question is more prevalent however than "How do I know how much to put on a trade?"

As a part of my "service" we offer individuals a spreadsheet that gives them an idea of what their overall risk tolerance should be dependent on their trade size. The spreadsheet also works in reverse. This is predominantly "basic math" but let's just go over it quickly. For example, if I am okay with losing $250 on a position and the options price is going for $1.00 my position sizing/risk tolerance will be the following according to my parameters set above:

5 Calls 50%

10 Calls 25%

20 Calls 12.5%

25 Calls 10%

50 Calls 5%

Obviously, the larger the position size the more you have to "thread the needle" for that position.

The second most common question I get:

"How do you know how far out your options should be?"

Absent of allegations of fraud or takeover noise, there is no "sure fire" way to tell just how far a stock can go both up or down. There are however tools/edges at your disposal to give you a sense of when you can/should leverage or when you can expect the potential for an outsized move. Notice I said "potential" in the above sentence. At the end of the day regardless of expectations or rationale, the market is irrational, and more often than not that is costly to your bottom line.

In simple terms, your options should be how far you perceive the move in question will in fact travel. Take into account that you want to be reasonable with your assessment and try keep your price objective within the measured move of the stock.

With the above diatribe over with, I want to share an example the above in action. Specifically how you can leverage father out of the money on major breaks (up or down) to get outsized returns on your capital. For the purposes of this exercise I want to highlight Facebook (FB).

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There are particular times when it is prudent to take stabs at exaggerative moves in the market. Though every trend book will tell you buy the breakouts and sell the breakdowns and you'll make money easily, that is not always the case. There are some key factors that can help you with your decision making process. Specifically I've found the following three items to consider prior to taking a potential trade.

The Overall Market
Catalyst
Stock's Trend

Overall Market

The first item I consider when taking a trade is the overall market. The questions being, what is the stock market currently doing? How is it preforming relative to the position I want to enter?

Put in layman's terms; do I want to short or go long? Is the overall market suggesting I should short or go long?

If you think of stocks as boats and the overall market as the river they flow on, you predominantly want to be in a boat attempting to go with the tide.

Since 70% of stocks tend to move with the overall market trying to move in the opposite direction is not prudent for your overall success. If I can put this scenario in a blunt image for you, don't be the stray gazelle in the Serengeti. We all know how that ends.

Catalyst

When taking a position, it is important to take note of if there is a catalyst at play for your move. Though not always necessary, if there is a catalyst, it does bolster the chances of our thesis coming to fruition. If we're using the boat analogy from above, a little wind in the direction you're going definitely gets your sailboat moving more quickly. Conversely, if there is an opposing catalyst, your chances for may be impeded.

TREND

This one is quite simple. Is there a particular trend for your stock? Or is it just dead money? It is more likely for your position to be accurate if you are trading either with the trend or when the trend breaks.

If you are trying to go long a stock, more often than not, staying with the uptrend for that stock will be beneficial for your overall success. That is of course unless the overall trend breaks. In that particular case trying for the opposite could prove to provide more bang for your buck.

As a general rule, the longer a trend the harder it is to break. Secondly, most trends don't break on their first attempt, but rather after multiple attempts at breaking.

In Action

I want to give an overall picture of the above in action. For this I will focus my attention on this week's FB trade. Going into the week FB had not traded particularly well as it finished August below its major MA's without the ability of breaking out.

As the above shows, Facebook was unable to break above a downtrend set prior to its blowoff top prior to earnings.

This next image shows how FB had been holding 170 as support after it's earnings report.

With the above in consideration, let's zoom out and consider any long term trends for FB.

Taking a look at the above, we notice that FB has been in a 4 year channel from April 2014. Like clockwork, the buys have come in on the bottom and the sells on the top. This channel was defended recently as well following a disastrous earnings report. That being said, FB had been acting weak and they were slated to present in front of congress again. The overall market wasn't helping either, as buyers abandoned ship yesterday seemingly being topped out by the AMZN $1T rejection one day prior.

Let's Highlight:

The overall market was weak
FB was in front of congress again
The recent trend was downward and reaching a critical point on the overall long term trend

In Action:

As the above was taking place we began stalking FB in the chat yesterday. I first highlighted it around 10am EST and gave the chart for the wedge it had formed and the long term trend. I then followed it up with an alert, taking the out of the money weekly 165P's as the stock hung precariously on the edge. Since the trend line in question is a four year trend line, I found it appropriate to leverage with farther out of the money puts in this case. Though this is how I chose to take my first attempt at this trade, this is not a practice that I encourage typically. More often than not, being too far out of the money will result in you wasting your money.

This position ended up working out for us immediately once the 170 level broke as the stock careened into 167.5 before finding some floor with the overall market. Unfortunately however, the stock did in fact find a floor and I was stopped out of a majority of my original position as it started to rebound. The stock started to form a new range between 167.5 and 169. It was important to make not of the breakdown level from that point on to decide whether or not to re-enter a position into the close. Secondly, it was important to note as a break of the lows would create further selling pressure. As the stock broke the intraday lows it was prudent to reapply my short of the stock; and thats exactly what we did.

With the stock selling into the close and breaking a multiyear trend, I found it prudent to put on an overnight position for the hopes of further selling and I'd make note of the previous days lows to get more aggressive with the stock should those lows continue to break. (highlighted below)

FB would be back on the top of my watch list yet again today. Within minutes, the overnight put position was in my favor and I could rest easy and raise my stops. From that point on, I made note of the previous day's close and the opening range lows as another catalyst point for selling as shown below.

The stock attempted to find a floor in the first half hour and subsequently attempted a run at the days opening price. A failure of that price suggested that any break below the opening range would result ini further downside. This was a safe bet as the stock had already broken a multiyear trend and closed on the lows just one day prior. With that in mind, and with a breakdown of the ORB I found it prudent to get more aggressive. I raised my stops on the overnight position again and added more puts (highlighted by the arrow below).

As you'll notice, once the position was on, the stock never recovered. It continued its escalator down until it came close to the 160 round number. By that time, we were all out of our puts and had rolled down our winners.

As a rule of thumb, I like to sell ~50% my winners once I see a 2x return. This allows me to avoid micromanaging the position and allows me to let it run its course to completion. All in all this trade worked out and was quite lucrative.

CLOSING

I opted to write this post primarily for two reasons: first, because I thought I'd finally put some of the "rules" I follow in writing to help answer some of the recurring questions I see/hear. Secondly, as I stated above, during times of market volatility my inbox blows up. This is an easy way to address all the common concerns and questions in one swoop. If you found this post helpful, please like and share it. If you'd like to learn more about how we trade feel free to reach out to me using the contact link on my website. As I stated, more and more people contact me during volatility. It is important to state, not all markets behave the same and this is not some cookie cutter method.

SHAMLESS PLUG

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Archives

5 Calls 50%

10 Calls 25%

20 Calls 12.5%

25 Calls 10%

50 Calls 5%

"How do you know how far out your options should be?"

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The Overall Market

Catalyst

Stock's Trend

Overall Market

Catalyst

TREND

In Action

Let's Highlight:

The overall market was weak

FB was in front of congress again

The recent trend was downward and reaching a critical point on the overall long term trend

In Action:

CLOSING

SHAMLESS PLUG