For traders who like to buy options.

Want to trade options on the long side? Then make sure you have a disciplined approach.

Begin by developing a model for selecting the underlying security; using either technical, fundamental or quantitative factors. Then, recognize that importance of risk management in determining the number of contracts to buy.

When you are long options – either calls or puts – it is about letting profits run and cutting losses. Never easy to do!

Most of us buy a stock with a target in mind. If the target is reached, the stock is sold. The problem with target selling, is that you can be taken out of a strong position prematurely.

Conversely, when a stock declines assuming no real change in the fundamentals, we average down. If you liked it at $50 you love it at $40. But, the strategy of averaging down, keeps you focused on a bad position and contradicts the concept of cutting losses. And neither approach works in a market where time is working against you.

Rather than setting targets when buying options, think in terms of risk management. One approach is to risk say, 3% of your account on each trade. Risk being the operative word.

Risking a set percentage of your portfolio means that you are successively risking less dollars during a losing streak, and more dollars, when winning. All of which fits the mantra of cutting losses and letting profits run.

Here’s an example that puts theory into practice. In a $50,000 trading account, risking 3% equates to $1,500. So, you like XYZ at $50 per share, and have set your mental stop at $45 (the 20 day moving average).

With $1,500 of risk capital, and a mental stop $5.00 below your purchase price. You opt to buy the XYZ six month 50 call. But how many contracts?

Establishing the number of contracts is not a function of the cost of the option. It is a function of the loss attributable to the XYZ 50 call should the stock decline to $45 per share.

You can use the options calculator to calculate the impact on the calls price should the underlying stock decline to $45 per share, If the calculator tells you that the call would fall by $3 per share assuming a $5 per share decline in the underlying stock, you would buy 5 call options (the 3% risk, $1,500, divided by the risk on one option, $300).

Proper risk management allows you to be successful in a high risk game. Typically, option buying strategies result in a larger number of unsuccessful positions. The objective is to make enough on one successful trade – i.e. letting profits run – to offset a number of bad positions where you were able to cut your losses.