It’s a well-known investment maxim that risk is correlated to reward.  But when it comes to options it seems people are often making claims to both consistently hitting singles while simultaneously being home run kings. When option volatility spiked to historical highs in March it became a ‘careful what you wish for situation” it was surfers always begging for bigger waves, but when they arrive the bash talk often heads to the safety of the sidelines. 

One of the keys to navigating the big wave is not just an honest assessment of your skill level, but employing appropriate risk management. Right, now the stock market is entering into a sweet spot for active (not maniacal) traders.  The VIX has settled into the 30% level—this where premiums are plump but not so fat the year fear things can blow up in your face at any time.  For an option trader with a modicum and knowledge and a healthy understanding of risk, there are many great opportunities.  

Dollars to Donuts 

But first, we need to be clear on our terms.  Returns must be based on dollars at risk.   Too often people mix and match these terms to put their results in the best light.  Meaning, if a call option they own increases in value from 50c to $1 they will tout the 100% return.  But if it expires worthless they will highlight the loss was limited to just 50c or $50 per contract, not that it was 100% loss.   Both of these are true of course but the varied emphasis can be misleading.  But at least when purchasing options the accounting is fairly straightforward.   The capital required and the risk are limited to the cost or premium paid for the position.  This is true for the straight purchase of a single strike or spread done for a debit.   

Because of the leverage of options, many long premium positions can deliver returns in excess of 100%.  Indeed if an option that goes from 20c to 50c that is 150% gain.  But if one only owns two contracts within a $10,000 portfolio that $60 gain translates into less than one half of 1% return on equity.  When it comes to selling options or positions done for to credit the accounting can become a bit more creative.    If it expires worthless a claim of a 100% return is often made.  If the option position sold for a 50c credit is forced to cover and bought back for a $1 it was “only” a 50c loss.   But even this does not accurately reflect the margin or capital required to establish the short position could have been greater than 50c and therefore the loss was even greater than 100%. 

Let’s look at a basic example in the: Spyder 500 Trust (SPY).”  With the SPY currently trading at $280, you can sell the $290 and buy the 290 call for $1.20 net credit for the spread in with a May 22nd expiration date.  

If shares of SPY are below $290 in May the position expires worthless and you keep the $1.20 premium as a profit.  But this is NOT a 100% return.  That’s because the margin or capital required to establish the position is $1.80.  That is calculated by the width between the strikes, which is $3, minus the premium collected, $1.20.   That $1.80 represents your maximum risk or loss that would be incurred if SPY is above $209 on the expiration date.

Therefore, the maximum profit of $1.20 represents a 66% return.  Not too shabby for a 10 day period but not the 100% claimed.  But that also means the potential loss of $1.80 translates into 150% or 1.5X the profit potential.  It is important to always keep in mind both the percentage and dollars at risk 

This concept of risk-adjusted returns is crucial when we begin to look at the risk/reward ratios of various options strategies.  In the next segment, I’ll look at how winning big can outweigh winning often but can bring its own pitfalls.   

To learn more about Steve Smith’s approach to trading and access to his Options360 service click here. 

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SPY shares were trading at $285.34 per share on Friday afternoon, up $0.37 (+0.13%). Year-to-date, SPY has declined -10.83%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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