Your explanation reminded me of a question I always had - I can buy 2 ATM options or 3 OTM for approx same price. Which one do I go for? I don't need to hold it till expiry. I've tried to analyze it but not sure if I have checked all possibilities.
LT, After knowing in spreads, u might have other choice as well..i.e buy 2 atm spreads or 5 OTM spreads.
It is the topic of position sizing (many call it money mgmt, risk mgmt etc), which answers "how much ?" part of trading jigsaw. And many successful traders agree that they got the breakout in their trading results only after getting this piece right.
If I can put it in simple terms,
(a) Size of account = 100000
(b) You decide to put 5% of account size as a Max risk on 1 trade so Risk per trade = 5000.
(c) You also decide to not put more the 20% of your account in one single trade = 20000. That means u can 5 trades of 10k each.. but your stops will ensure that u don't loose more then 5k in each of them giving u max loss of 25k if all 4 go against you. (I am using these absurd ratio of 5 and 20 here as example. In real life, I will reduce to more reasonable limit)
Depending on trade you are selecting, you know your risk of that particular trade which is (entry price - stoploss price). In case of spread, or option trade, it can be the net premium that u pay but u
can decide on your stoploss limit and decide to take lower risk.
Say Your entry price 85, and stop as suggested by charts or your strategy is 65. So you are taking 20 pts risk.
Divide 5000/20 to get the position size = 250.. i.e.5 contracts (as 1 contract = 50 underlying of NIFTY). So as per point (b) above, you can buy 5 contracts.
As per point (c) above, in 20000, you can buy 20000/85 = 235 i.e. 4 contracts.
So you just go ahead with minimum of 5 or 4.. and stay within sensible trading boundries as you have defined for yourself.
If your risk turns out to be 80 rs.. then your position size will be = 5000/80 = 60 i.e 1 contract.as per point (b)
This is as simple as I can explain about Position sizing at level 0. As position moves in your favour, you risk starts turning into profit, and u might decide to add extra contract and still keep the
risk within 5k limit but enhance the profit potential..
Whether u buy ATM/ ITM/ OTM / Spreads has nothing to do with HOW MUCH part. Factors that decide selection of OTM /ATM depends on your view about the trend, trend strength so that OTM
has chance to become ITM, time left till expiry, distance of OTM from current spot level etc..
Once u have decided that you want to buy OTM or ITM, then come back to above calculation to decide on HOW MUCH.
Not the other way, where u decide to buy OTM cause they cost less and you can afford to buy more contracts there. Those OTM will loose fast and hit the 5k risk limit on very comparatively smaller adverse move.
Hope this helps.. (maybe you already know all this but atleast it can help others)
Happy Trading