I was recently asked about the optimum amount to start a portfolio. My answer? Start with a strategy and work your way backward from there.
A clear strategy defines how much capital you’ll need, how to allocate it, and how to protect it. Today, let’s explore the logic behind portioning a trade, diversifying, and setting realistic expectations. This framework will help you navigate the markets with discipline and patience.
Strategy First: Setting Realistic Expectations
It’s important to approach trading with a healthy dose of realism. Short-term virtual portfolios can deliver thrilling returns, but that’s largely due to luck or a few fortuitous trades. Relying on luck is dangerous. Instead, consider long-term plays that focus on steady gains.
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Short-Term Portfolio: Reserved for a small percentage (e.g., 25%) of your total portfolio. This is for speculative trades that involve higher risk and potential reward.
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Long-Term Portfolio: Focuses on safer strategies like buying LEAPS (Long-Term Equity Anticipation Securities) and selling puts and calls against them. This approach aims for consistent income generation.
Success hinges on a mix of these strategies—a balance between short-term excitement and long-term stability.
Diversification: Protecting Your Capital
Diversify across sectors and strategies. This minimizes the risk of a single bad trade crippling your portfolio. No matter how confident you feel, avoid concentrating more than 20% of your portfolio in one sector.
Example of Sector-Based Thinking:
A long call option on ExxonMobil (XOM) is essentially a bullish bet on oil prices. Pairing this with a long call on Dow Inc. (DOW) would not diversify your portfolio because they both react to the same factor—energy prices.
Instead, diversify into unrelated sectors:
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Tech: Microsoft (MSFT), Apple (AAPL)
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Healthcare: Johnson & Johnson (JNJ), Pfizer (PFE)
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Consumer Staples: Procter & Gamble (PG), Coca-Cola (KO)
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Financials: JPMorgan Chase (JPM), Goldman Sachs (GS)
Position Sizing: The “Just Right” Allocation
Effective position sizing is about balancing opportunity with protection. Here’s a breakdown of how to allocate capital for a trade:
Portfolio Structure:
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25% Short-Term Speculative Plays: High-risk trades, like earnings plays or momentum-based options.
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75% Long-Term Strategies: Safer, income-generating positions, such as covered calls or diagonal spreads.
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40-50% Cash Reserve (in each portfolio): Always keep enough cash to double down, adjust, or exit trades without stress.
Individual Trade Sizing:
For options, start with units of $500 or $1,000 per trade. Limit initial uncovered positions to 50% of your planned total allocation. This allows room to double down or roll if the position moves against you.
Worst-Case Scenario Planning:
Using this approach, even if a sector is wiped out (20% of your portfolio) and you lose 50% of that allocation, your total portfolio loss is limited to 10%.
Real-Life Examples: Thoughtful Execution
Example 1: Short-Term Trade
You purchase 10 call contracts on Tesla (TSLA) at $1.50 each, totaling $1,500. As the stock rallies, the options reach $2.00. Instead of holding overnight and risking a reversal, you sell for a 33% gain.
Example 2: Long-Term Trade
You buy a LEAPS call on Amazon (AMZN) with a two-year expiration and sell a short-term call against it. This “covered call” strategy lowers your basis while generating income.
Patience is key here. The goal is to gradually reduce the basis of your LEAPS until you’re left with a free position that delivers pure profit.
The Goldilocks Entry: Finding Your “Just Right”
Every trader’s situation is different, so finding an entry strategy that’s “just right” for your portfolio is critical. If your resources don’t align with your strategy, your plan is doomed before you start.
Key Rules:
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Start Small: Don’t overcommit on speculative trades. Build positions gradually.
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Take Profits: A 20-40% gain in an hour is better than risking overnight losses. Don’t let greed derail your discipline.
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Avoid Fees Eating Profits: Smaller positions can get wiped out by transaction costs, so scale accordingly.
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Set Realistic Expectations: Options trading is risky. If you aim to outperform the S&P 500, understand the increased risks involved.
Final Thought
Options trading is not about swinging for the fences. It’s about making steady, disciplined gains while managing risk. Stick to your strategy, stay diversified, and maintain a healthy cash reserve.
Remember, the market will always offer new opportunities. Patience, planning, and discipline will help you succeed in the long run.
All the best,
— Phil
