How Risk-Reward Is Tied to the Probability of Profitability
By: Steve Smith
Yesterday, I discussed how I’m employing credit spreads to ease into new bullish positions. The reasoning behind this approach is two-fold: Current implied volatility levels are elevated, offering nice premiums and good risk/reward set-ups, and I don’t need to be exactly right to be profitable.
Today, I’d like to discuss how risk/reward is tied to the probability of profitability. It’s a well-known investment maxim that risk is correlated to reward. But, with options trading, people are often making claims that they’re consistently hitting singles while also blasting home runs.
First, we must 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. Case in point, if their call option increases in value from 50 cents to a dollar, they’ll tout a 100% return. However, if it expires worthless, they’ll highlight the loss was limited to just 50 cents, or $50 per contract — not that it was 100% loss.
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Both of these are true of course, but the varied emphasis can be misleading. However, at least when purchasing options, the accounting is fairly straightforward. The capital required and risk is limited to the cost, or premium paid for the position. This is true for the straight purchase of a single strike, or for a spread done for a debit.
Due to the leverage of options, many long premium positions can deliver 100%-plus returns. Indeed, if an option goes from 20 cents to 50, that’s a 150% gain. But, if one only owns two contracts within a $10,000 portfolio, that $60 gain translates into less than one-half of a 1% return on equity.
With selling options or positions done for a 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 50 cents, credit is forced to cover and bought back for a dollar, it was “only” a 50 cent loss. But, even this doesn’t accurately reflect the margin or capital required to establish the short position, which could’ve been greater than 50 cents. 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 around $390, you can sell the $390 and buy the $293 call for $1.20 net credit for the spread with a March expiration date.
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If SPY shares are below $290, then the position expires on March 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’s 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 $293 on 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.
However, that also means the potential loss of $1.80 translates into a 150% or 1.5X profit potential. It’s always important to keep the percentage and dollars at risk in mind. This needs to be in the context of each individual position and the overall portfolio.
This concept of risk-adjusted returns is crucial when starting to look at the risk/reward ratios of various options trading strategies. In the next segment, I’ll look at how winning big can often outweigh winning but can bring its own pitfalls.
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