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How Simple is a Simple Options Trade? Like all options setups, short puts do involve risk (see risk plot below); however, I won’t spend time covering the details on how this setup works. Instead I’ll assume you have a general knowledge of how to enter and exit a short put position. What I would like to discuss is how we enter such trades, namely, what are the tradeoffs we make in trade selection by analyzing a moderately volatile stock. Trade selection involves choosing the optimal strike price and expiration cycle relative to your trading objective. In this article, I’ll focus on strike selection with a future article looking at the various choices for expiration date. It is interesting to compare the tradeoffs of strike selection from the standpoint of the put being in-the-money (ITM), at-the-money (ATM), out-the-money (OTM), and further OTM. This gives us a comprehensive spectrum to make comparisons, but recognize that the tradeoffs span across the entire option chain. We consciously or subconsciously evaluate tradeoffs at every strike, not only when crossing the distinct boundaries above. The challenge to consistently evaluate and make decisions in a nearly infinite spectrum of trades with a similar objectives was the core problem we looked to solve when developing our options ranker software. Let me share with you at a high-level how this challenge is structured. For this discussion, we will use 3M Corporation stock (MMM), a moderately volatile issue (market beta of 1.15) trading at a 52-week high-low range (as of March 1, 2019 close) of $241.35-$178.62 and a current price a closing market price of $207.39 per share. The Dilemma of Tradeoffs in Strike Selection MMM trading at $207 in the market presents different strike selection choices when writing a put. What drives your selection of a strike price, however, creates an interesting dilemma. For example, if you choose an ITM setup, what is the actual goal, what are the risks relative to the moderate volatility of MMM and what do you give up in comparison to a strike selection that is ATM or OTM? A look at the near-term puts for MMM (March 8 based on the March 1st close for the strike intervals between 202.50 (deep OTM) and 210.00 (ITM), here’s what you would have seen: MMM Mkt$ = $207.39 (March 1, 2019) Strike Price Premium (Bid) Extrinsic Value Position 202.50 0.36 0.36 Deep OTM 205.00 0.77 0.77 OTM 207.50 1.59 1.48 ATM 210.00 3.00 0.39 ITM Moving from deep OTM (202.50) to ITM (210.00) at entry, the premium received increases with each strike. This is a consequence of a bullish outlook. The higher premium for the ITM strike is a product of its extrinsic and intrinsic values. The Curious Behavior When Shorts Puts are ITM With MMM trading a little over $207, we could choose a strike price of $210 to put on a trade slightly ITM. We might do this if we were particularly bullish, in order to capture as much premium as possible. However, when the short put is ITM at entry this places the you at risk of exercise and erodes the premium received from extrinsic value. This raises two interesting questions as to the relative risk of establishing a short that is approximately 2-½ points ITM vs. at or out-of-the money: First, is the higher payout worth receiving an exercise notice prior to expiration – potentially forcing you to purchase the shares? Second, is the trader’s bullishness better expressed in a complementing position or instrument considering the extrinsic value is so severely eroded? Being ITM creates some urgency for the put writer, because the longer the position remains open, the more likely exercise by the holder will take place as the remaining extrinsic value will continue to erode. This can be exacerbated if the stock will soon go ex-dividend. In a sense, the play begins to take on characteristics of a long call vs. a short put. This sense of urgency may be tempered somewhat with a stock of moderate volatility since breakeven (intrinsic + extrinsic) may not be breached. Comparing Greeks Across Strike Selection Let’s now look at the Greeks (Delta, Gamma, Theta) at trade entry for short puts on MMM that are ITM, ATM, OTM, and deep OTM to see how they compare. While the Greeks are not the only tradeoffs to consider across the strikes, it does give us a good picture on how the positions behave and differ from one another. Before we make our high-level comparisons, let’s first define the “ideal” values for each of the Greek parameters. “Ideal Parameters” when Shorting Puts Delta (measures the price change of an option relative to a change in the price of the underlying stock) – usually as premium sellers we’re looking to minimize our delta exposure. This allows us to have less volatility in our position with small moves in the underlying. The exception to this rule is when we’re using short positions ITM or deep ITM as we’re using the position for a directional play. Gamma (measures the options delta exposure to movement in the price of the underlying stock) – Similar to delta, we want the changes to delta to be minimal with small moves in the underlying. Gamma is usually described as a risk (gamma risk) for premium sellers. It is the buyer/holders friend as it provides the leverage. Theta (measures the change in the option’s price relative to time) – This is our primary profitability criterion as premium sellers. We want to see as much theta decay as possible with minimal movement in the stock. Gamma and Theta are strongest pitted against each other. Value of Greeks – Short Put ITM Let’s now look at the Greeks (Delta, Gamma, Theta) for an ITM short put which pay $300 in premium. The values at entry are as follows: Delta– the delta of an ITM short put on MMM shows –0.74 which means that as the price continues to move below the strike price by $1 the put will become $0.74 more expensive to buy back. In other words, the ITM position is closely mimicking the underlying stock and will increase to a delta of -1.0 with the effect of gamma. Gamma– the gamma for the short put that is ITM should move slower than the fall in the underlying stock – somewhere about 0.09. This means a $1 drop in the price of MMM would result in a 0.09 increase in the negative delta, bringing it even closer to parity with the underlying stock. Theta– theta for the ITM short put is 0.065 $/day. Therefore, with no price movement you can expect the position to make $6.50 per day. Theta only erodes the extrinsic value in the option, so we will see the greatest theta ATM and reduced theta with the ITM option here as a lot of the premium is associated with intrinsic value. Due to this, the underlying stock must increase in value above the strike of the option (210) for the option to expire with no value. Value of Greeks – Short Put ATM At-the-money lessens exercise risk for the writer and provides the highest amount of extrinsic value received in the premium. Using the 3M option chain from above with a strike of 207.50 (sold for a premium of $1.59 or $159), the maximum profit received by the writer is $159. The Greeks for this position are as follows: Delta – the delta of an ATM short put would move about –0.491 with the market price. You may already know that absolute value of delta estimates the probability that the option expires in the money. It’s easy to understand why this approximation works in this example as the trader has approximately a 50/50 shot that the option will expire out of the money at expiration. Gamma – the gamma for the short put that is ATM should decrease the delta by 0.1. For the same expiration cycle, gamma will exhibit the largest effect ATM. Theta – theta for the ATM short put, as option’s remaining life decreases, is 0.10 $/d, which is the highest we see across all the strikes . Therefore, ATM short puts provide a significant theta opportunity with a tradeoff of high gamma. Value of Greeks – Short Put OTM For an OTM short put, with a strike of 205 and paying $77 in premium, the Greeks are as follows: Delta – the delta of an OTM short put is about –0.27. As the as underlying stock increases by $1/share we’d expect the short put to lose $0.27 in value which is a unrealized profit for the short put trader. When compared with above, you can see that the trader has a higher probability that the put will expire worthless (approx.. 73%). Gamma – the gamma for the short put that is OTM is 0.08. The gamma risk is reduced as we have more “downside protection” by selecting the put further out of the money. Theta – theta for the OTM short put is $0.094/day, which is less than the ATM option but more than the ITM. This shows how much the extrinsic value erodes when ITM options are selected. Value of Greeks – Short Put Far OTM A further OTM setup makes the likelihood that an exercise will take place is next to nil. Maximum profit is significantly reduced to $36, but the probability of profit is also the highest at c.a. 85% (1 – delta). Again, looking at the deep OTM setup for MMM (say $202.50), the Greeks for are: Delta – the delta of a deep OTM short put is around –0.15, which is the lowest delta across the group giving the highest Probability of Profit and highest downside protection. Gamma – the gamma for the short put that is deep OTM is 0.05, meaning that the delta will not see large swings even if the stock moves against the position gradually. Theta – theta for the deep OTM short put is $0.08/day, which is the lowest profitability we’ve seen for theta decay but still greater than the ITM put which becomes a directional bet. Conclusion Here is a summary of the values discussed in this article according to the position of the short put relative to the underlying stock: Strike Delta Gamma Theta ($/day) Probability of Profit Premium (intrinsic + extrinsic) Premium/Return on Capital ITM 210 –0.740 0.087 –0.065 ~26% $300 Highest ROI ATM 207.50 –0.491 0.099 –0.100 ~50% $160 Moderate ROI OTM 205 –0.272 0.077 –0.094 ~78% $77 Low ROI Further OTM 202.50 –0.145 0.047 –0.075 ~85% $36 Lowest ROI Strike price selection when creating a short put setup dictates potential profit and loss risk potential. In summary: Short put, ITM at entry = highest risk, highest ROI, becomes a directional play Short put, ATM at entry = moderate risk, moderate ROI, highest theta decay Short put, OTM at entry = low risk, low ROI, maintains strong theta and tradeoff with gamma. Short put, deep OTM at entry = lowest risk, lowest ROI, easy to over-leverage if notional risk not properly considered. It’s apparent from the colors in the table, that a common “rule of thumb” for short put trading is to select strikes slightly out-of-the-money. However, I hope this article challenges you to be more scientific in your strike selection, expand your evaluation of key trading criteria, and recognize that the tradeoff of risk and reward is in continuum across the strikes. There’s no one-size-fits-all rule of thumb. In the next article, we’ll explore the tradeoffs of expiration cycles with short puts. I would appreciate your feedback and questions on this article as it will help developing the second part. Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging. You can follow Drew via @OptionAutomator on Twitter.

Part of approaching markets probabilistically is ensuring that your trades, on average, make money. Traders use several metrics like risk/reward ratio, Sharpe ratio, profit factor, and win rate to estimate what they should expect from their average trade. However, your risk/reward ratio and win rate are the basic building blocks you'd use to understand how your average trade performs. From your risk/reward ratio and win ratio, we can make a rough calculation of your expected value or how much you can expect to earn from your average trade over a large sample size. Knowing your expected value allows you to project how your portfolio will perform over time. Before that, let's settle on what your win rate and risk/reward ratio mean in trading. What is a Win Rate in Trading? Put simply, your win rate is the percentage of your trades that show a profit. A 60% win rate trader makes money on 60% of his trades. Too many novices are taken by the allure of a high win rate. After all, how many advertisements for Forex trading courses advertise a high (80%+) win rate? But we must remember that a win rate only takes into account the percentage of trades you win, not how much you win or lose on each trade. You can quickly devise a very high win-rate trading "system" with little work. Simply buy an option or stock and immediately submit a limit order to sell it one tick higher than your purchase price. Have no stop loss. Most of the time, the security will trade above your purchase price, and you'll win almost all of your trades. However, because you have no stop loss, sometimes you'll lose most or all of your capital employed. You probably don’t need telling that this is a very poor and unprofitable trading strategy despite its high win rate. Conversely, a low win rate is undoubtedly not a disqualifying factor for the quality of a trading system. Futures trend followers like the Turtle traders of the late 1980s are a famous example of traders who win around 30% of their trades yet are profitable because their winning trades are way bigger than their losing trades. What is a Risk/Reward Ratio in Trading? Just a technicality here to avoid confusion. While the nomenclature in trading culture is to refer to this metric as a risk/reward ratio, what traders are typically referring to is the reward/risk ratio, which places 'reward' as the numerator. From here on out, we'll refer to the reward/risk ratio. Just keep in mind that when most traders say "risk/reward," they're really talking about reward/risk. As options traders, we have the gift of being able to shape our reward/risk ratio in nearly any way we'd like. Unlike delta one markets like equities and futures, it's much easier to fix our risk and reward levels using options spreads surgically. If you want a 2.0 reward/risk ratio, you can likely construct that using a vertical spread. If you're looking for substantial home runs, you can potentially find a profitable way to get long out-of-the-money options while remaining sensible. The primary thing to keep in mind is that you subsidize your risk/reward ratio with your win rate. In other words, you can't have a high win rate and a high risk/reward ratio or vice versa. We'll get into the specifics as to why soon. You can calculate your reward/risk ratio you need two pieces of information: How much you intend to risk on a given trade How much you estimate to win should the trade work out in your favor. Perhaps we intend to risk $100 per trade when we lose and gain $150 when we win. The calculator is as simple as $150/$100 = 1.5. 1.5 is our reward/risk ratio, meaning we can expect to earn 1.5x more on our winning trades than on our losing trades. While a positive reward/risk ratio is often sold as a holy grail, the options market is not that simple, and you cannot approach options trading the way a delta one equity trader does. After all, buying out-of-the-money calls yields a very high reward/risk ratio, often higher than 10. But your likelihood of actually winning those trades is very low. After accounting for the low win rate, it's frequently an unprofitable strategy. On the other hand, strategies like selling volatility can have low reward/risk ratios of 0.2 and still be profitable. Sure, your losing trades will be huge, but you'll win most of your trades. Some short-volatility traders can get so in tune with the current market cycle that they can go 20-30 trades before they have one that blows up in their face. So we cannot view our reward/risk ratio in a vacuum. We'll demonstrate this more when we talk about expected value, which combines reward/risk and win rate. The point here is that reward/risk, and win rate is linked. You can't really manipulate one without affecting the other. If you want a high win rate, you must accept an unfavorable reward/risk ratio and vice versa. There's no free lunch in markets where you can achieve a 3:1 reward/risk ratio with a 70% win rate, save for rare illiquid, and unscalable situations. This should be self-evident, too. If a trader can consistently make trades in liquid markets with an expected value like this, he'd own the entire capitalization of the stock market in no time. While most traders direct the strong form of the efficient markets hypothesis, few would deny that markets are efficient enough to deny you opportunities to print money with little risk by allowing you to systematically and scalably trade with a high risk/reward ratio and a high win rate. Let's demonstrate this, too, so you can viscerally understand how you can't have the best of both worlds regarding reward/risk and win rate. What is Expected Value in Trading? Imagine I offered you even money to bet on a fair coin flip. The expected value of this game is zero. Let's say you pick tails. Each time the flip comes up tails, you win a dollar, each time it comes up heads, you lose a dollar. Because the odds of tails and heads hitting are even at 50%, you can expect to make $0 per flip over a large sample size of coin flips. However, if I altered the odds so that you win $2 for tails and lose $1 for heads, this game's expected value is now $0.50 per flip. We can calculate this with a straightforward formula: (Amount won per trade * probability of winning the trade) - (Amount lost per trade * probability of losing the trade) It’d look like this for our updated coin flip game: ($2 * 0.50) - ($1 * 0.50) = $0.50 Hopefully, it goes without saying that if someone ever offers you odds like these, take them all day. This is expected value in a nutshell. Wikipedia puts it like this if you want a more technical definition: The expected value is the arithmetic mean of a large number of independently selected outcomes of a random variable. Demonstrating Expected Value in Trading The combination of reward/risk ratio and win rate is your expected value. It's a formula that answers the question, "given my probability of winning a trade, how much can I expect to win per trade, over a large number of trades, given my reward/risk ratio?" We'll use the example of a 3:1 reward/risk ratio and a 70% win rate, risking $100 per trade. First, we calculate the expected value of the average trade using the same simple formula we used for our coin example: (Amount won per trade * probability of winning the trade) - (Amount lost per trade * probability of losing the trade) Our formula would look like this: Remember that this is an entirely unreasonable combination of win rate and reward/risk and is meant to demonstrate the folly of searching for the golden system that gives you both. Doing an elementary compounding calculation in Excel also shows you this. If we start with a bankroll of $10,000 and risk 1% (or $100 as in the example above) and make four trades a week, at the end of the year, our bankroll would be 360K, representing a 3,775% annual return. Of course, this is based on an expected value of $180 per trade without any variance calculations, but it shows how the market works. You can have a high reward/risk or high win rate. Pick one. Bottom Line To summarize: Win rate refers to how often you win your trades. High win rates typically mean unfavorable reward/risk ratios and vice versa. The market lets you choose if you want a high win rate or a high reward/risk ratio, but not both, except in the rarest of cases. Knowing and understanding both your win rate and your reward/risk ratio is essential, and you can't solely rely on one metric. Expected value represents the combination of win rate and reward/risk and tells you what you can expect to earn on your average trade.

Lets examine those statements and see how you should put them in context and consider other parameters as well. We will use vertical spread strategy as an example. Lets take a look at the following trade: Sell to open RUT August 1175 call Buy to open RUT August 1185 call This is the risk profile of the trade: As we can see, we are risking $822 to make $177. This is pretty bad risk reward. However, the picture looks a lot better when we look at the probability of success: it is 78%. We need the underlying to stay below 1175 by August expiration, and there is 78% chance that it will happen. In this trade, bad risk/reward = high probability of success. Lets take a look at another trade: Sell to open RUT August 1100 call Buy to open RUT August 1110 call This is the risk profile of the trade: As we can see, we are risking only $185 to make $815. That's terrific risk/reward (more than 1:4). The only problem is that RUT will have to go below 1110, and there is only 20.7% probability that this will happen. (In fact, to realize the full profit, RUT has to go below 1100 and stay there by expiration). In this trade, excellent risk/reward = low probability of success. The following table illustrates the relation between probability of success and risk-reward: Of course, this is not an exact science, but it helps us to see the approximate relation and trade-off between the risk-reward and the probability of success. So next time someone will ask you: "Would you risk $9 to make $1?" - consider the context. Yes, it is a terrible risk/reward, but considering high probability of success, this is not such a bad trade. It will likely be a winner most of the time - the big question is what you do in those cases it goes against you? At the same time, the answer to the question "Would you risk $1 to make $9?" is also not so obvious. It is an excellent risk/reward, but the probability to actually realize this reward is very low. In trading, there is always a trade-off. You will have to choose between a good risk-reward and a high probability of success. You cannot have both. Watch the video: If you want to learn more about options strategies: Start Your Free Trial

After 7 years of bull market, many traders forgot the meaning of risk. They think they can just buy call options and/or sell puts and make outrageous digits returns every year. I suggest that everyone reads Mark's post, it's an excellent read with a lot of wisdom. Is selling naked puts a good strategy? Mark's response is fairly long - here are the most important points: "This is not a conservative strategy. Not even close. It is a high probability play, with many profitable months. I cannot imagine a strategy in which I earn a profit month after month for several years. Yet this strategy could provide those results. The question is: how much is at risk? No matter what anyone tells you about risk, you just know that either nothing terrible is going to happen, or if it does happen that you will react in plenty of time. Let me assure you that in Oct 1987, puts were not buyable at any price that you would have been willing to pay. You did live through the winter of 2008, but if you have truly been doing this for 24 months, you began at the right time. You missed out on the excitement of Sep and Oct of that year. Have you considered what would have happened had you begun in August 2008, instead of 3 or 4 months later? If you have access to TradeStation (or if your broker offers back-testing – I believe thinkorswim does), go back to August expiration, choose options to sell for the Sep and Oct expirations and then follow the trades." I am NOT telling you what to do, but you have not been through what I have. You have not seen how quickly money can vanish from your account. What is your risk/reward? We are familiar with some services that advocate selling naked puts on 25-50% of their portfolio. In our opinion, this is a financial suicide. This strategy obviously performed very well in the last few years. Interestingly enough, the track record of those services usually doesn't go beyond August 2011, not to mention October 2008. One of them has data going back to 2009 (again, not 2008 ), but August 2011 is missing. Coincidence? To give a fair margin of safety, the strikes are usually far enough from the money to give you around 2-3% potential return on margin. Well, 2-3% per month sounds very good, but what about the risks? In a month like August 2011 (not to mention October 2008) the loss could easily reach 30-50%. In October 2008, it could wipe out your account. Is 2-3% per month worth the risk? The latest case of Karen the Supertrader who implemented similar strategy of selling naked options provides a good example of the risks. How our strategies handle risk? Let's take a look at our strategies and see how they handle risk. SteadyOptions At SteadyOptions, we trade a mix of non-directional strategies. They might include Iron Condors, Calendars, bufferflies, earnings straddles etc.. The idea behind earnings straddles is buying a straddle 5-10 days before earnings and hold it till earnings. The strategy is based on my Seeking Alpha articles Exploiting Earnings Associated Rising Volatility and How To Rent Your Options For Free. We expect the IV increase to offset the negative theta and/or book some gamma gains in case the stock moves. In periods of low IV, the earnings trades are expected to produce 3-5% average return, and theta positive trades like ICs and calendars are expected to provide us most of the gains. However, the earnings trades serve as a nice hedge to the theta positive trades in case of a quick and sudden move. To see how they performed when the markets become volatile, take a look at August 2011 returns here or July 2012 returns here. Those trades are basically our black swan event insurance, and we get it for free - in fact, most of the time we even make some money on it. Anchor Trades An Anchor trade's goal is to prevent loss of capital while still generating a positive net return in all market conditions. This strategy began with the premise that it must be possible to virtually fully hedge against market losses, without sacrificing all upside potential. It is expected to lag the S&P 500 in a strong bull market like 2013. In 2013 the lag was larger than expected due to poor selection of stocks. Going with ETFs instead of stocks would lag the S&P only by few percentage points, which means that the hedge almost paid for itself. The impact of not experiencing losses in down market years, while only slightly lagging (if lagging at all) in positive and neutral years, is astronomical over any extended period of time. Again, it is very easy to become complacent in the current bull market - but the market will correct at some point. It's not a matter of if but when. And when it does, you will be thankful that you are hedged. As an example, the Anchor return in May 2012 was +4.6% while S&P plunged -6.2%. In 2008 when S&P was down 38.4%, the Anchor was up 27.9%. Steady Condors Steady Condors is a market neutral, income generating, manage by the Greeks strategy. The trades are primarily risk managed variations of iron condors. The big difference (in addition to how the adjustments are made)between the Steady Condor main trade (MIC) and the "traditional" Iron Condor trades is the fact that MIC uses a put debit spread plus some far OTM puts for black swan event protection. This protection is placed when the trade is initiated - in other words, we buy protection when we want to, not when we need to. The result is that in case of market crash or black swan event, the trade actually becomes vega positive and those hedges provide an excellent protection. We conducted a case study for the August 2011 trade (available on members forums). It's a fascinating read. During the life of the trade, RUT was down over 11% - yet the trade was closed at profit target of 5% on Aug. 4. Interestingly enough, on Aug. 8 RUT closed down 64 points at 650. If you wouldn't have taken the trade off on the 4th the trade would actually have been up 67% at the end of the day on the 8th. This is the power of protection, combined with exploding Implied Volatility. Conclusion When comparing different strategies, don’t forget to consider both historical performance AND historical drawdowns in both up and down markets. Mark asks the following question: "How much will you lose if the market opens 20% lower one day, RUT IV (RVX) moves to 90 or 100, and the option markets get very wide?" This is your stress test - does your portfolio pass it? Want to see how we handle risk? Start your free trial