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 ris k 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 und erlying 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 mist ake. 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
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
- The original price per share.
- Price of the underlying when the trade is opened.
- Strike of the option.
The analysis of premium at risk should encompass risk and
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.
- Human Nature and Option Risk
- Relative Yield of an Option
- Long Option Risks
- Option Payoff Probability
- Fundamental Volatility and Stock Prices
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