How to Manage Buying Power Risk in Small Option Accounts
How to Manage Buying Power Risk in Small Option Accounts
By:Kai Zeng
Three management techniques help us traders control naked options effectively in small accounts
- Buying Power Expansion is a critical risk that tastybite traders should monitor closely. BPR spikes can significantly increase the risk in small accounts.
- To reduce buying power impact, focus on lower-priced underlyings for higher premium-to-BPR ratios. That improves capital efficiency and creates trading opportunities.
- Higher IV Rank offesr reduced BPR at equivalent stock prices.
Small-account traders face specific challenges when selling naked options, including naked puts, calls, strangles, jade lizards or any combination with naked positions.
One challenge is the higher buying power requirement (BPR). Naked options require much greater BPR than risk-defined strategies, which can restrain the use of capital.
Another challenge comes with volatile BPR, which fluctuates with naked options. Potential BPR expansion can significantly increase the percentage of capital allocation.
This time, let’s focus on how BPR changes and affects a portfolio when the following criteria change: underlying price levels, underlying price movement or the level of implied volatility. Here are some considerations.
1. Focus on Lower-priced Stocks
Not only do high-priced stocks require significantly more BPR to start with, but also their premium-to-BPR ratios might not be as good as some cheaper alternatives. To trade naked options effectively, these low-priced stocks can help keep our capital use in a healthy range.
2. A quick stock price change that moves closer to the strikes can increase BPR
This affects our capital allocation. A large move in IWM, such as 15%, can increase an existing position's BPR by more than 200% from the initial order entry. If IV increases at the same time, the BPR expansion can be even higher.
Here are some of the largest moves in the S&P 500 and the 1SD strangle's BPR changes in the past two decades. Two observations: First, large stock price swings toward or exceeding the strikes can quickly increase BPR. Second, for similar magnitude moves, BPR expands even faster on the way up than during pullbacks.
The worst-case scenario is 3.6x more BPR than at order entry. It means that if we deployed 30% of the capital in a $20,000 account at order entry, it would end up using all of the available capital quickly unless it’s managed carefully. That's why holding positions for too long usually causes performance to deteriorate. Early management can reduce tail risks from large market moves.
3. High IV Rank can help reduce BPR at the same stock price levels
This improves capital efficiency. The Nike example demonstrates how high IV Rank reduced BPR by 23%, compared to low IV environments.
Mastering these three BPR management techniques will help us trade naked options more effectively in small accounts while maintaining proper capital allocation throughout different market conditions.
Kai Zeng, director of the research team and head of Chinese content at tastylive, has 20 years of experience in markets and derivatives trading. He cohosts several live shows, including From Theory to Practice and Building Blocks. @kai_zeng1
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