Risk, Reward and Probability

Risk with Options:

In options trading, “risk” refers to the potential for losing part or all of the invested capital due to the asset’s price moving contrary to the position taken. It is quantifiable and varies with different options strategies, from the limited risk of buying options to the unlimited risk of selling naked options. Effective risk management strategies, including setting stop-loss orders, diversifying positions, and understanding the Greeks, are essential to mitigate potential losses.

What is the worst that can happen? When you are trading options, this is your “max loss” on your potential trade – this is what you are risking.

You also need to consider slippage, commissions and fees. If you think you are going to hit your stop loss at 20% don’t be surprised if you have a realized loss of 22% when you factor in those other costs.

Reward with Options:

“Reward” in options trading signifies the potential financial gain achieved from successful trades, which can vary from fixed, predictable profits to unlimited earning potential. The leverage provided by options allows traders to achieve significant returns on investment with relatively small capital, especially in strategies like buying calls or puts. However, maximizing reward requires careful selection of strike prices, expiration dates, and an accurate reading of market conditions and volatility.

What is the best possible outcome? That is your max gain on a potential trade – your total potential reward.

Side note: Slippage, commissions and fees are another topic – but they are a significant part of your profitability and they can’t be ignored. They drag down your reward and they increase your risk. Don’t forget to back out commissions, slippage and other fees. Your 20% limit order might only be a 19% realized gain.

Risk / Reward:

Risk and reward in investing are intricately related, forming the basis of investment decisions. Investors typically aim to achieve the highest possible expected return while carrying an acceptable level of risk.

The relationship between risk and reward is such that investments with higher potential returns usually come with higher levels of risk, while safer investments tend to offer lower returns. This dynamic is driven by the concept that potential reward serves as an enticement for taking on increased risk.

The market is very efficient and very competitive – which means if there are low risk high reward opportunities the market will find them and exploit them very quickly. As these opportunities are exploited either the risk or the reward factor is adjusted until the ratio of risk to reward is properly priced. Buyers and sellers will capture all this reward until there is a very slim

As they say, there is no free lunch.

In the world of finance, understanding this risk-reward trade-off is crucial. Calculating the risk-reward ratio in options trading involves dividing the potential reward by the potential risk. For instance, if the potential reward is $100 and the potential risk is $50, the risk-reward ratio would be 2:1.

Probability of Profit

Would you rather risk one to make two or risk two to make one? Pretty obvious choice right?

Well not so fast, the risk reward relationship is incomplete without one more important detail: the probability of profit. Risk 1 to make 2 with a probability of profit of 30% performs much worse than risk 2 to make 1 with 70% probability of profit.

Now with these three variables, Risk, Reward and Probability you can start to systematically address your option investments, trades and hedges.

But wait, theres more. You also must factor in the size of your portfolio and the optimal size of your position using the Kelly Criterion. Do you want to make a great trade or do you want to grow your account over time? Realize those are not the same thing. Link in the description.

P.o.P. Defined: The probability of profit in options trading refers to the likelihood of a particular options trade being profitable. It is not to be confused with the probability of an option finishing in-the-money (ITM). The probability of profit indicates how often a trader would be profitable if they make an options trade and do not manage the position.

Let’s say a stock is trading at $100 and you can buy a 100 strike call option for $5. Let’s now consider a few choices and outcomes.

ChoiceStock Up $5Stock Down $5Stock UnchangedPnL
Buy Call0-5-5-10
Sell Call0+5+5+10
  • Notice how when you buy a call, and it goes up, you can still lose.
  • Notice how when you sell a call, and it goes up, you can still win.

How can this be possible?

Because option sellers are taking on the tail risk, option buyers are paying for their insurance and option sellers are receiving it.

If you consider that the stocks movement is random, and assume a range between 75 and 125 then a significantly higher percentage of outcomes end up being profitable for sellers relative to buyers. This gives option sellers a higher probability of profit, a higher number of potential outcomes end up with at least .01 in profit – relative to option buying.

Selling/Credit: Your max gain is limited only to what you receive – what you were paid when you opened the position. Risk is limited only by where the stock can go. If you sell a put, your max loss would be the stock could go to zero. If you sell a call the stock could go to infinity.

Receiving Credit:

  • Definition: Receiving credit in options trading refers to a scenario where the premium collected from selling options is greater than the premium paid for buying options.
  • Cost Structure: Involves an initial inflow of cash (credit) into the trader’s account when establishing the position.
  • Profit and Loss: Maximum profit is capped at the initial credit received, while the maximum loss is limited to the difference in strike prices minus the net credit received.
  • Volatility: Benefits from a decrease in implied volatility and also from time decay, as the options sold lose value over time, benefiting the trader who is a net seller of premium.
  • Advantages:
    • Income Generation: Credit spreads allow traders to collect premium upfront, providing an income-generating strategy.
    • Positive Theta Decay: By selling out-of-the-money spreads, traders benefit from positive theta decay, profiting from time passing even if the stock price remains stable.
  • Disadvantages:
    • Collateral Risk: Traders may need to risk more collateral than potential gains due to probability favoring out-of-the-money options remaining worthless.

Buying/Debit: Risk is limited only to what you invest – what you paid to open the position. Your max loss is limited by the amount you paid for the position. Your max gain on puts is limited by the stock’s lower bound: zero. Your max gain on calls is unlimited because the stock could go to infinity.

Paying Debit:

  • Definition: Paying debit in options trading occurs when the premium paid for buying options is greater than the premium received for selling options.
  • Cost Structure: Requires an initial outlay of cash (debit) from the trader’s account when setting up the position.
  • Directional Bias: Generally used when traders have a moderate directional bias (bullish or bearish) on the underlying asset.
  • Profit and Loss: Maximum loss is limited to the initial debit paid, while the maximum profit is also capped.
  • Volatility: Can benefit from an increase in implied volatility, although this effect is usually small since a spread involves both buying and selling options. However, time decay works against traders paying debit spreads as they have outlaid a net premium to establish the spread.
  • Advantages:
    1. Limited Risk: Debit spreads limit the trader’s risk exposure, ensuring that the maximum loss is restricted to the amount paid for the spread.
    2. Lower Cost: They are often more cost-effective compared to other options strategies, making them suitable for traders looking to manage risk without significant capital outlay.
    3. Profit Potential: While capping risk, debit spreads still offer profit potential if the underlying asset moves in the predicted direction.
    4. Versatility: Debit spreads can be utilized in various market conditions, including bullish, bearish, and neutral markets.
  • Disadvantages:
    1. Limited Profit Potential: Despite offering profit potential, the maximum profits are capped due to the nature of buying and selling two options.
    2. Limited Time Frame: Debit spreads have an expiration date, requiring traders to be correct about the asset’s direction before expiry.
    3. Complexity: They can be challenging for beginners to grasp due to involving buying and selling two options simultaneously.
    4. Margin Requirements: Some brokers may impose higher margin requirements for debit spreads, potentially increasing trading costs.

Credit, Debit, Risk and Reward Summary

  • Risk: Your max loss.
  • Reward: Your max gain.
  • Probability: Probability of profiting $.01 on the trade.

This is a critical distinction between buying and selling options – which of the following two teams do you want to play for?

  • Team Credit: Lower risk, lower reward, higher probability?
  • Team Debit: Higher risk, higher reward, lower probability?

Now that you know the difference between these strategies, you have to choose a type of risk: defined or undefined?

Are you willing to go to zero (or beyond) with this trade? Or, will you define your risk in advance?

Defined Risk Options Trades

Defined risk: When you establish your own max loss before you put the trade on. Your downside and upside are limited.

Defined risk trades in options trading are strategies where the maximum potential loss is known and limited right from the moment the trade is placed. This concept applies to both debit and credit trades, offering a safeguard against the unpredictable movements of the market. Let’s explore how defined risk trades manifest in both contexts.

Defined Risk in Debit Trades

In debit trades, you’re essentially buying options—either calls or puts. The cost of buying these options (the premium paid) represents your total risk. This is inherently a defined risk scenario because the most you can lose is the premium you’ve paid to enter the trade, no more.

But beyond just the purchase of single options, defined risk can also come into play with more complex strategies like debit spreads. A debit spread involves buying and selling options of the same type (both calls or both puts) on the same underlying asset but with different strike prices or expiration dates. The maximum loss here is still limited to the net premium paid for the spread, making it a defined risk trade. This strategy not only limits potential losses but can also reduce the upfront cost compared to buying a single option.

Defined Risk in Credit Trades

Credit trades, where you receive money upfront by selling options, can also be structured as defined risk trades. This is achieved through strategies like credit spreads, which involve selling an option and buying another option of the same type (call or put) on the same underlying asset, but again, with different strike prices or expiration dates. The difference between the premium received from the option sold and the premium paid for the option bought is your initial net credit, and also represents your maximum potential profit.

The risk in these trades is defined because the maximum loss is limited to the difference between the strike prices of the two options, minus the net credit received. For example, in a credit spread, if the market moves against your position, the loss is capped at this calculated maximum. This setup provides a safety net, ensuring that, unlike in naked options selling, you won’t face unlimited losses.

For example:

  • You might set a stop loss 50% of the trades value – so that you get out at a particular price saving you from potentially further losses.
  • You might have a credit spread or iron condor (other multi legged strategy) where your max loss is the distance between your strikes.
  • Selling covered call options to generate income with limited risk or using risk reversal strategies to limit downside risk while maintaining upside potential.

Undefined Risk:

Undefined Risk: You could go to zero, or beyond on this trade. There is no limit to your upside or downside.

Debit Trades and Undefined Risk

When you enter a debit trade by purchasing options, you pay a premium upfront. This premium is the maximum financial loss in a direct sense; you cannot lose more money than you initially invested. However, this investment has the potential to become worthless, which represents a 100% loss of its value. This drastic reduction in value—from its original price to zero—highlights a form of undefined risk, not in terms of additional monetary loss beyond the initial investment but in the total loss of the investment’s value itself.

Credit Trades and Undefined Risk

Credit trades, on the other hand, are where undefined risk primarily comes into play. These trades involve receiving a credit upfront by selling options. If you sell a naked option (without owning the underlying asset or a corresponding opposite position in the same asset), the potential loss can be substantial. For example:

  • Selling Naked Calls: If you sell a call option without owning the underlying stock, and the stock price skyrockets, your loss can grow indefinitely since there’s no cap on how high a stock price can go.
  • Selling Naked Puts: If you sell a put option without a corresponding strategy to limit loss, and the stock price plummets to zero, your loss can be significant, though it’s capped at the stock price going to zero minus the credit received.

In these credit trade scenarios, you face undefined risk because there’s no limit to the amount you could lose. The market can move against you in extreme and unpredictable ways, leading to potentially unlimited losses.

Understanding undefined risk is crucial for traders, especially when engaging in strategies that involve selling options. It’s essential to assess risk tolerance, employ risk management strategies, and consider using defined risk trades when appropriate to avoid unexpected and potentially unrecoverable financial damage.

The Significance of Choosing Defined or Undefined Strategies

Defined risk strategies are essential for traders who seek to manage their exposure to potentially catastrophic losses. But in a more important and tactical way defined risk strategies allow traders to calculate their maximum potential loss upfront, which aids in portfolio risk management and decision-making. Whether engaging in debit or credit trades, the ability to define and limit risk is a critical tool in the trader’s arsenal, providing a balance between seeking profits and managing potential losses.

In short, defining the risk limits a universe of potential outcomes and fixes two variables: risk and return. There is always a tradeoff, there is no free lunch.

Detractors of defined risk strategies will tell you that undefined risk outperforms over time, but this is usually applicable to large accounts and experienced traders (or algorithms). Choose what works best for you.

Regardless of defined or undefined risk, here are some high risk and low risk option strategies to consider:

Low-Risk Options Strategies:

  1. Covered Calls: This strategy involves holding shares of a stock and selling call options against them. By doing so, traders can collect premium cash upfront and enhance their positions in stable stocks like Apple, Microsoft, or Tesla while reducing their cost basis. Covered calls provide a cushion against downturns and lower the risk while setting the stage for increased profitability.
  2. Short Puts: Selling short puts with deltas ranging from 30 to 70 can align the worst-case exposure closely with that of holding 100 shares of long stock. This strategy mirrors the risk-reward profile of long stock but with potentially better outcomes. Short puts can be used to enhance long exposure more effectively than traditional stock holdings, offering a strategic approach to managing risk and maximizing returns.
  3. Iron Condor: The iron condor is a masterful options strategy designed for stable stocks where traders set up two out-of-the-money short vertical spreads – a short put spread below and a short call spread above the current stock price. This strategy thrives in scenarios where stock prices remain relatively stable, allowing both spreads to expire worthless and leaving the trader in a winning position.

These low-risk options strategies provide traders with opportunities to generate income, reduce risk exposure, and enhance their portfolio’s performance while maintaining a strategic approach to options trading.

High Risk Options Strategies:

  1. Naked Calls: Selling naked call options is considered one of the highest risk strategies in options trading. In this strategy, the option writer is obligated to sell shares at the strike price if assigned, but since stock prices can potentially rise indefinitely, the risk is unlimited. While selling a naked call option can yield potential profits, it comes with the possibility of significant losses if the stock price rises sharply.
  2. Naked Puts: Similar to naked calls, selling naked put options involves significant risk. The option writer is obligated to buy shares at the strike price if assigned, with the potential for unlimited losses if the stock price declines substantially. While this strategy can generate income and benefit from stable or rising stock prices, it exposes traders to high levels of risk due to the unlimited downside potential.
  3. Uncovered Options Selling: Strategies involving uncovered or naked options selling carry substantial risk due to the unlimited loss potential. Uncovered options selling includes selling calls or puts without holding an offsetting position in the underlying asset. Traders engaging in uncovered options selling face significant risks as they are exposed to potentially large losses if the market moves against their positions.

Putting it All Together:

  • You can’t make a trading plan, or have consistent success if you don’t know the inputs to your own strategy. In order to have more consistency some level of agency over your success you have to have a deep understanding of the risk, reward and probability of each and every one of your trades.
  • Choosing between debit and credit strategies is an active decision to be on a particular side of risk and reward – debits are higher risk (gasp) higher reward. Credits are lower risk lower reward.
  • Defining your risk on each trade can help you “fix” your outcomes to be more predictable, measurable and mechanical. Undefined risk strategies can have asymetric results both positively and negatively. Limited risk inherently means limited reward.

Do you have any questions on these topics? Post them in the comments section below and I will be sure to get back to you with a response. If you found this content helpful, consider creating your free IntraAlpha account for more great content like this.