Generating steady income from options is attractive: premium flows, time decay working in your favor, and a wide menu of strategies from covered calls to credit spreads. But the same leverage and asymmetric payoff that make options lucrative also create concentrated downside risk if you size positions poorly. I approach options income the same way I approach real estate or equities: start with clear allocation rules, measure potential loss, and build in explicit limits and contingencies so one bad trade doesn’t wipe out hard-earned gains.
Set clear portfolio-level guardrails
Before sizing any single options trade, decide how much of your overall portfolio you’re willing to dedicate to options income. In practice I recommend:
These guardrails keep options from dominating your portfolio and let you scale up or down without changing your playbook.
Choose the right income strategy for risk control
Different income strategies have different risk profiles. Match the strategy to your objective:
For income with explicit downside limits, I favor vertical credit spreads and covered calls; they provide income while making the maximum loss either known (spreads) or tied to an underlying I’m willing to hold (covered calls).
Quantify worst-case loss and size accordingly
Every options trade has a worst-case scenario. For a cash-secured put or a covered call, the obvious risk is the stock moving sharply against you. For a credit spread, the maximum loss is strike width minus net premium. I always compute the dollar loss if the worst-case occurs and then ensure that loss fits my per-position cap.
Example: you sell a 1.00-wide credit spread and receive $0.25 premium. Max loss = $1.00 - $0.25 = $0.75 per share -> $75 per contract. If your per-position cap is 2% of a $200,000 portfolio = $4,000, you could hold up to 53 contracts (4,000 / 75 ≈ 53). But you wouldn’t actually hold that many because of liquidity, margin, and correlation considerations—practical sizing often reduces theoretical max to a rounder, more conservative number.
Use the Kelly-lite idea for allocation (practical adaptation)
Full Kelly is too aggressive for most investors because it aims to maximize long-term growth with high variance. Instead, I use a fraction of Kelly tailored to income strategies to set allocation alongside worst-case caps.
Kelly-lite gives a systematic baseline for sizing but should be used with the absolute per-position and portfolio caps described earlier.
Factor in probability, Greeks, and implied volatility
Premium size and the probability of adverse moves matter. Two trades with identical premium can have wildly different risk if one is in high implied-volatility (IV) stock with fat tails. I consider:
Translating Greeks into position size means: if vega or gamma is large for a given premium, cut size by 20–50% relative to a trade with comparable premium but calmer Greeks.
Practical sizing worksheet (simple table)
| Metric | Example | Interpretation |
|---|---|---|
| Portfolio value | $200,000 | Base for allocation |
| Max options allocation | 10% = $20,000 | All options positions combined |
| Per-position cap | 2% = $4,000 | Max loss you accept on any single position |
| Trade: 1.00-wide credit spread | Premium = $0.25 → Max loss $75/contract | Contracts max = 4,000 / 75 ≈ 53 (practical ~40) |
| Trade: covered call (100 shares) | Stock cost = $5,000; premium $200 | Position uses cash or margin; cap by 1–3% rule |
Account for liquidity, margin, and slippage
Paper math aside, market realities matter. Tight bid-ask spreads and regular volume reduce execution slippage and allow cleaner exits. I reduce theoretical size if:
Brokers matter too. Interactive Brokers and Tastyworks offer different margin benefits and assignment handling—know your broker’s rules on assignment, margin interest, and option exercise windows before sizing trades.
Plan for management and predefined exits
Sizing is only half the battle—active management prevents small positions from becoming catastrophic. Before opening a trade I set rules:
Automating alerts for these triggers in your broker platform saves reaction time and emotional decisions.
Stress test and iterate
I treat each new sizing rule as an experiment. Backtest on historical scenarios and run forward-looking stress tests: what happens if IV doubles, the stock gaps 15% on earnings, or the sector collapses? Use scenario analysis to decide if your position size still meets the per-position cap.
Finally, keep a trade journal. Record the rationale, sizing, Greeks, and outcomes. Over time you’ll see which sizing heuristics work for your portfolio, temperament, and chosen strategies—and that real-world feedback is the best risk-management tool.
