It’s a well-known investment maxim where risk is correlated to reward. But, when it comes to options, it seems people are making claims to both consistently hitting singles while simultaneously being home run kings.
In the next three articles (this is one of three), I want to explore how returns should be calculated, whether it’s possible to achieve both a high percentage win rate along with high percentage returns. And finally, which options strategies offer the best probability of consistent profitability.
Dollars to Donuts
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 it’s a call option, they own increases in value from 50 cents to $1, they will tout the 100% return. But, if it expires worthless, they will highlight that the loss was limited to just 50 cents or $50 per contract, not that it was a 100% loss. Both of these are true of course. But, the varied emphasis can be misleading — 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 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 20 cents to 50 cents — that is a 150% gain. But, if one only owns two contracts within a $10,000 portfolio that a $60 gain translates into.
When it comes to selling options or positions done for credit, 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 50-cent credit is forced to cover and bought back for a $1, it was “only” a 50-cent loss. But, even this does not accurately reflect the margin or capital required to establish that the short position could have been greater than 50 cents 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 trading at $267, you can sell the $270 and buy the $273 call for $1.20 net credit for the spread in with a January expiration date.
If shares of SPY are below $270 on the position expires January 19th 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 $273on the expiration date.
Therefore, the maximum profit of $1.20 represents a 66% return. Not too shabby for a 30-day period, but not the 100% claimed.
But, that also means the potential loss of $1.80 translates into a 150%, or 1.5x the profit potential. It is important to always keep in mind both the percentage and dollars at risk. This needs to be in the context of both each individual position and the overall portfolio.
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 also bring its own pitfalls.
About the Author: Steve Smith
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...