OptioNewton

Risks 

Before trading it is important to understand the risks (or the complement of risk, the probability of success) of the trade. Purchasing a stock and buying and writing calls and puts are reviewed here. Evaluation of more complex strategies can be extrapolated from these. 

Although trades can occur at any point during the month, to be conservative and for simplification, it is assumed the transaction is initiated at the end of the previous month's opex day and completed at the next opex. It's simplified because predicting the time value portion of the premium during the month has a lot of uncertainty associated with it. It is 100% certain, however, that all OTM options will be worth zero on opex. And in fact, a majority of options do expire unexercised.

Buying a stock - there are 3 possible outcomes after the purchase of a stock; 1. The stock price rises and a profit is realized. 2. The stock price is at or near the same price it was when originally bought. Or 3. the stock price declines and there is a loss. Of the possible outcomes, only 1 is successful, so the probability of success is 33% (1/3). If it is assumed that the not losing money outcome is null, then their are two possible outcomes and the probability of success is 50% (1/2) or the same as a flip of a coin. This is illustrated in the following figure.

Buying a call - again there are 3 possible outcomes. 1. The underlying stock price rises and the call premium is much higher than when it was purchased and has a large profit. 2. The stock price is about where it was when the call was bought and either the call is OTM and expires worthlessly or the call is ITM, but due to Time Value decay its premium is worth less than when it was purchased resulting in a loss. Or 3. the stock price has declined and the call is OTM and worthless. This is illustrated in the following figure.

Buying a put - also has 3 possible outcomes. 1. The underlying stock rises and the put premium goes OTM and expires worthlessly. 2. The stock price is about where it was when the put was bought and either the put is OTM and expires worthless or the put is ITM, but due to Time Value decay it's premium is worth less than when it was purchased resulting in a loss. Or 3. the stock declines substantially and the put premium is much higher than when it was purchased resulting in a large profit. The figure would be similar to that for buying a call, except with the put, there would be a loss when the stock rises and a profit when the stock falls. The chance of success would be the same, ie 1 in 3 or 33%.

Writing a call - 3 possible outcomes. 1. The underlying stock rises and the call premium is much higher than when it was sold and when bought back results in a loss. 2. The stock price is about where it was when the call was sold and either the call is OTM and expires worthless in which case the seller is credited with the entire premium to his account or the call is ITM, but due to Time Value decay it's premium is worth less than when it was purchased and the seller makes a profit by buying back the call at a lower price than when it was sold. Or 3. the stock price has declined and the call is OTM and the seller is credited with the entire premium as a profit. There are 2 successful outcomes of the 3 possibilities, so the probability of success is 66.6%. This is illustrated in the following figure.

Writing a put - 3 possible outcomes. 1. The underlying stock rises and the put expires OTM and the entire premium is credited to the seller's account as a profit. 2. The stock price is about where it was when the put was sold and either the put is OTM and expires worthless in which case the seller's account is credited with the entire premium or the call is ITM, but due to Time Value decay it's premium is worth less than when it was sold and the seller makes a profit by buying back the premium at a lower price than when it was sold. Or 3, the stock price has declined and the put is ITM at expiration, the premium is higher than when sold and the seller has a loss on the difference in the premium. The figure would be similar to writing a call except there would be a profit on the upper stock move and a loss on the lower stock move. The results would be 2 successful outcomes of 3 possibilities and the probability of success is 66.6%.

The outcomes and probabilies of success for the above or any combination of stock and option can be summarized in a matrix. The following illustrates the ones discussed above.

The take away from this might be several things; 1.) to position probability in the trader's favor, or the most successful trade to make, is first a function of the trader's aniticpated market or stock direction. 2.) that before making a trade the trader needs to completely understand the possible outcomes and 3.) to understand the  actions necessary to take when one of generally 3 outcomes occurs. A corrollary could be, since selling options provides a probability of success as much as double that compared to buying them, then it might be wise to include selling options as part of a strategy. Further, in general since the longer the time to opex the higher the time premium and the shorter the time to opex the lower the time premium, it would make sense that selling options when there is a long time to opex and buying options when the time to opex is short (especially in earnings announcement months) may also contribute to a higher success rate.

Profit Expectations

Profits on owned options can range from a few percent to several hundred percent. Theoretically, profit can be unlimited. Losses on owned options can range from a few percent to several hundred percent of the premium. So owned options can be considered high profit potential with minimal risk of loss. On wrrtten options, profits can vary from a few percent to 100% of the premium. Losses on written options can vary from a few percent to several 100%. Theoretically loss is unlimited, so writing options can be considered minimal profit potential with a potential high risk of loss.

The higher risk of loss in writing options is somewhat countered by its higher probability of success. In addition, this high risk of loss can be mitigated by purchasing OTM options for protection and is common in many strategies such as in the vertical spreads. Further the portion of the capital used in trading options and therefore the profits and losses, even the higher ones, can be a small fraction of the overall portfolio, as it should be. But if options are a small percentage of the portfolio, it doesn't mean successful options trades can't still contribute to substantial returns for the portfolio over the long run.

For example, let's say the portfolio can net 5% per month. Over 12 months assuming simple interest, ie not compounded, the return is 60% for the year. If compounded, ie the profits are reinvested, the annual return at 5% per month is 80%. Compare this to the average return of a buy and hold stock strategy with returns on average of 5 to 10% per year. So, when judging the performance of an option trade, if an investor can achieve a net return of 25, 50, 100% or more on an option trade (which aren't uncommon) above and beyond commissions in a month and it has contributed even just a few percent to the overall portfolio in the month, then over the long run, he will do well.

With regard to commissions, many options strategies consist of 2 or 4 legs. Each leg and the entry or exit of the transaction can incur a brokerage commission. These can consume a large portion of the net profit on options trades. A few things to consider include; 1.) using a realible brokerage firm with the smallest commission fees possible, 2.) using strategies that either have the lowest net premium possible and/or 3.) using strategies that don't require executing the closing side of the transaction. That is, ones where it is hoped the options will expire or will be exercised and executed automatically on opex without having to pay a commission to exit the position.