SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

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

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 430 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 874 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 779 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 467 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 1,474 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 5,886 views
  • Call And Put Backspreads Options Strategies

    A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that a stock will move quickly in one direction. Call Backspreads are used for trading up moves; put backspreads for down moves.

    By Chris Young,

    • 0 comments
    • 9,485 views
  • Long Put Option Strategy

    A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is Delta negative, Vega positive and Theta negative strategy. A long put is a single-leg, risk-defined, bearish options strategy. Buying a put option is a levered alternative to selling shares of stock short.

    By Chris Young,

    • 0 comments
    • 11,132 views
  • Long Call Option Strategy

    A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is Delta positive, Vega positive and Theta negative strategy. A long call is a single-leg, risk-defined, bullish options strategy. Buying a call option is a levered alternative to buying shares of stock.

    By Chris Young,

    • 0 comments
    • 11,516 views
  • What Is Delta Hedging?

    Delta hedging is an investing strategy that combines the purchase or sale of an option as well as an offsetting transaction in the underlying asset to reduce the risk of a directional move in the price of the option. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds. 

    By Kim,

    • 0 comments
    • 9,657 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