SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.


Should options traders consider “premium at risk” when entering strategies? Most traders focus on calculated maximum profit or loss and breakeven price levels. But inefficiencies in option behavior, especially when close to expiration, make these basic calculations limited in value, and at times misleading.

Premium at risk is not often brought up in the discussion of options, but it should be considered as one of many factors in identifying the true risk involved. Strategies such as covered calls tend to exhibit great variance based not only on time decay, volatility, and open interest, but also on one other factor: selection of the underlying security.

 

Many traders tend to think of the underlying only as the vehicle for protecting option risks, or for reducing required collateral in order to enter a position. The selection of one underlying over another often defines and even sets risk levels. It is even more variable based on the covered call strategy a trader picks:

 

Because there are so many choices, covered call strategies usually fluctuate widely from one trader to the next. Some traders opt to write long-term calls in order to eliminate the hassle of rolling their positions every month. Others choose to write significant out-of-the-money calls in order to maximize the upside potential of their portfolio. [Longo, M. (2006). Buying a young index: A new wrinkle in familiar strategy. Trader Magazine, 1]
 

To many traders, this selection and timing of the call itself is the only variable that matters. But this means the underlying selection often is overlooked, and this is a mistake. An appreciation of the relationship between return and risk is a constant concern for trading options, but this extends beyond the option alone, and must be applied to the underlying, or the premium at risk calculation. Behavior of the underlying should be used to identify an exit strategy or when the time to roll out of danger appears. Focus only on the option easily overlooks this key analysis of risk assessment:

 

One of the simplest exit strategies for securities is selling if the given security falls by a certain percentage. If the underlying security drops by a certain percentage, the option position is closed … there are also stay-the-course strategies such as double-up, covered call and the rollover. These strategies attempt to make the most of a bad situation by increasing the chances to recoup or limit any loss. [Elenbaas, T. & Tsou, D. (Fall 2006). Risk management for option writers. Futures, 35, 22-24]
 

The inherent problem in the strategies designed to offset losses is that they often represent ramping up of the risk. The chances of increasing the loss rather than becoming a viable recovery strategy, involve both the option positions and the underlying. This could be taken to mean it is more conservative to take losses when they occur and free up capital to move to another position.


The premium at risk extends beyond the option itself, so rolling over or increasing covered call positions, is not always reasonable. Traders also need to be aware of the risks of holding on to the underlying when the value is declining. If no options were involved, a trader might exit to cut losses, and this is a rational approach to risk management. But when option positions are open, judgment might not be as clear. A trader might stubbornly want to avoid losses and will increase option positions with the idea of recapturing paper losses. But at the same time, the underlying is losing value and the longer this continues, the worse the position might become.


For analysis of how risk affects a portfolio, option traders are vulnerable. They may be analyzing impressive annualized returns from relatively limited dollar value of covered calls, for example, while ignoring what is going on with the underlying. Even if the underlying holds value without much change, is it a “good investment?” Options traders may view the underlying as a vehicle for reducing option risks, but does it make sense to keep capital tied up in a position that is not growing in value?


It must be assumed that even covered call writers will prefer to see underlying equity positions becoming profitable over time. This is especially true if the covered call strategy is to write deep out of the money positions. If the underlying price  moves upward and surpasses the strike, profits are possible from three sources: covered call premium, capital gains on the underlying, and dividends.

This is the best of all worlds, but options traders might also tend to sabotage their original good intentions. Increasing the exposure (premium at risk) often is how this occurs. A trade is nice and profitable on a percentage basis, but the dollar amount was not that great. The next position might involve buying more shares and writing several calls, with the idea of greater dollar returns. This ignores the premium at risk, because price movement does not always move in the desired direction – as every experienced options trader knows.


The real profit from options trading should take every aspect of risk and return into consideration and increasing the risk in hopes of realizing equally higher return should not be taken up in isolation. There are three factors to be brought into the assessment:

  1. The original price per share. If the underlying has appreciated in value since entry, much greater flexibility in the option is possible. This means a strike should be selected out of the money, but able to produce a respectable capital gain in the event of exercise. Options traders may avoid exercise by rolling, but it often makes more sense to take the gain and move to another trade.
     
  2. Price of the underlying when the trade is opened. How does this price compare to basis in the underlying? While this is an obvious factor to consider, some traders set up trades when the price is lower than basis, meaning a strike is selected poorly as well. If exercise would create a capital loss in the underlying (especially one higher than the profit on the call), this entry makes no sense.
     
  3. Strike of the option. The timing of the covered call matters, and the “best” available strike must be selected with the basis in the underlying in mind as well.

The analysis of premium at risk should encompass risk and return, not just return. Too many traders have a blind spot about this, which explains why consistent profits often are elusive.

 

Michael C. Thomsett is a widely published author with over 90 business and investing books, including the best-selling Getting Started in Options, now out in its 10th edition with the revised title Options. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on Seeking Alpha, LinkedIn, Twitter and Facebook.

Related articles

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • How To Manage Fear And Greed In Trading

    Why doesn’t everyone get involved in trading? And why doesn’t everyone “hit it big” on the stock market at least once? If you eliminate the main factors that drive the human mind (emotions) and only consider knowledge, logic, experience, and reason, everyone should be able to earn money from trading.

     

    By Kim,

    • 0 comments
    • 102 views
  • Probability vs. Certainty Trap

    We all would like all our trades to be winners, but we know this is not possible. We know some of the trades will be losers. Many traders think that if a trade has lost money, it was a bad trade. They try to identify what errors they made that lead to losses. Why? "Because I lost money! So surely I have made a mistake somewhere?”

    By Kim,

    • 2 comments
    • 6,431 views
  • How To Choose The Right Platform For Your Stock Trading

    The interest in stock trading has increased due to its higher returns and profit potentials. Like the many traders available, there are numerous approaches and platforms to set your trading environment. Online trading platforms provide adequate resources and tools for their clients' trading success.

    By Kim,

    • 0 comments
    • 2,007 views
  • How To Approach Passive Investing

    Passive investing refers to an investment technique that seeks to increase returns by limiting purchasing and selling. One of the most popular passive investment strategies is index investing, this means that a group of investors buy a representative benchmark, and keep hold of this over a long period.

    By Kim,

    • 0 comments
    • 1,961 views
  • How Anchor Survived the 2020 Crash

    We are often asked how the Anchor strategy performed during the market crash of 2020. The monthly performance can be seen on the performance page, but it shows the End of Month values and doesn't tell the whole picture. This article will shows a detailed analysis of the Anchor portfolio during the crash.

    By Kim,

    • 2 comments
    • 3,628 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 3,779 views
  • Got Crypto? Here's How to Use It

    Cryptocurrencies are fast becoming an accepted personal and corporate finance method - much to the chagrin of centralized banks and established financial institutions. The reasons are numerous, but in a nutshell, the decentralization of massive amounts of currency poses a threat to their systems.

    By Kim,

    • 0 comments
    • 2,487 views
  • Option Payoff Probability

    Many options analyses focus on profit, loss and breakeven. These show what occurs on expiration day, assuming the option remains open to that point. But this is not realistic. Most options are closed or exercised before expiration, is calculation of how probable a payoff is going to be, how likely the loss, or the exact neutral outcome (breakeven), are all unrealistic.

    By Michael C. Thomsett,

    • 0 comments
    • 1,859 views
  • How to Open Your Own Trading Office

    Are you ready to break out on your own? Have you been trading for a company for years making tons of money for yourself and others? Are you ready to take home a bigger piece of the pie? If you answered “yes” to these questions then you have the skills necessary to take your passion for trading to the next level.

    By Kim,

    • 0 comments
    • 2,613 views
  • How To Create Your Own Indexed Annuity

    Indexed annuities are a life insurance company product sold by insurance brokers for a commission that is based on the amount deposited into the contract. Contract performance is linked to popular indexes like S&P 500, and early withdrawal penalties typically apply for the first 7-10 years if withdrawals greater than 10% of the contract value are taken each year.

    By Jesse,

    • 0 comments
    • 3,062 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido