Sizing by max loss and by vega

The risk management course sized stock trades by the distance to a stop. Options positions need two more rules, because a defined-risk spread has a max loss that no stop is required to enforce, and because a book of short premium has a second dimension, vega, that can lose money with every stock in the book unchanged. This lesson gives a sizing procedure that handles both, using a $50,000 account throughout.

Rule 1: max loss per position

No single defined-risk position may lose more than 2% of the account at its maximum: $1,000.

Contracts = floor($1,000 ÷ max loss per contract).

Two percent is a common figure, not a law; the fundamentals course used 1–3% depending on how often the max loss is reached. For structures that are managed at 1–2× credit and rarely reach max loss, some traders use a larger figure; for structures held to expiration like butterflies, the max loss is a real possibility and 2% is honest.

Rule 2: sum of max losses

The sum of max losses across all open positions may not exceed 20% of the account: $10,000.

This is the rule from Module 3's tail lesson written as a number. If every defined-risk position in the book reached max loss in the same week, which is the scenario a crash produces, the account would lose 20% and continue. Ten condors at $844 each would breach it; that is the signal to hold fewer positions or smaller ones. Positions on different underlyings do not diversify this number much in a crash, which is why it is a sum and not a correlation-adjusted figure.

Rule 3: vega

A 10-point rise in implied volatility across the book may not cost more than 3% of the account: $1,500. So net weighted vega must stay above −$150 per point.

This catches what the first two rules miss. A book of small condors can pass rules 1 and 2 and still be short so much vega that an ordinary volatility event hurts:

Within the limit: a 10-point IV rise costs about $612, 1.2% of the account, before delta and gamma effects. Add three more condor positions at the same size and the book is near −$100; add a ten-lot strangle at −$12 each and it is at −$220, past the limit while every individual position still passes rule 1. The vega rule is what says no at that point.

The vega number should be the weighted vega from Module 1 (scaled by √(30/DTE)), because a 10-point move in 60-day IV is a much larger event than a 10-point move in 7-day IV.

Rule 4: undefined risk

Strangles and naked options have no max loss to size by. Size them by a stress scenario instead: the loss if the underlying moves two standard deviations against the position and IV doubles, and hold that to the 2% limit.

Short strangle 44/56 on XYZ at $50, credit $1.05, 45 days. A two-standard-deviation drop is about $10.50, to $39.50; with IV at 60% the $44 put at that point is worth about $8.00 (4.50 intrinsic plus 3.50 extrinsic) and the call is near zero. Loss ≈ 8.00 − 1.05 = $6.95 per share, $695 per strangle. Rule 1 allows one contract. The margin requirement at that point would be roughly $1,100, about double the initial. If one contract seems small for a $50,000 account, that is the correct conclusion about a strangle on a $50 stock; the structure is capital-efficient only under portfolio margin (next lesson) and only until it is not.

Which rule binds?

  Position            Rule 1 (max loss)   Rule 3 (vega)   Rule 4 (stress)
  2 condors               binding           slack             n/a
  6 iron flies            binding           slack             n/a
  13 calendars            binding           n/a (long vega)   n/a
  10-lot strangle         n/a               binding           binding (1 lot)
  whole book of shorts    slack (each)      binding (sum)     -

The procedure

1. Compute max loss per contract; apply rule 1 to get the contract count.
2. Add the position's vega (× contracts) to the book's weighted vega; if the book goes below −$150, reduce or skip.
3. Add the position's max loss to the book's sum; if it goes above $10,000, reduce or skip.
4. For undefined risk, compute the stress loss and apply rule 1 to that instead.
5. Record all four numbers in the trade log before entry.

Rules 2 and 3 are the ones that stop a good month from turning into an oversized book. Every position looked fine on its own in February 2020.

Key idea: Size defined-risk positions so the max loss is under 2% of the account, keep the sum of all max losses under 20%, keep net weighted vega above −$150 per point on a $50,000 account (a 10-point IV rise costs no more than 3%), and size undefined-risk positions by a 2-SD-plus-IV-doubling stress loss. The vega and sum rules are the ones that say no when each position individually passes.

Try it: List every option position you hold with its max loss (or stress loss for undefined risk) and its weighted vega per contract. Compute the four rule numbers for your account size. If any rule is breached, write down which position you would cut first and why. Then use the options profit calculator to confirm the stress loss on the largest undefined-risk position, if you have one.

Recap

• Rule 1: max loss per defined-risk position ≤ 2% of the account; contracts = floor(limit ÷ max loss per contract).
• Rule 2: sum of all max losses ≤ 20%; a crash makes the sum, not the average, the relevant number.
• Rule 3: net weighted vega such that a 10-point IV rise costs ≤ 3%; this catches a book of individually small short-premium trades.
• Rule 4: undefined risk is sized by a 2-SD-move-plus-IV-doubling stress loss held to the 2% limit.
• Record all four numbers before entry; the sum and vega rules are the ones that stop over-sizing.