Trade Review: When Options Are Too Risky

03/08/2012 7:00 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Option traders must carefully consider risk/reward parameters, writes Josip Causic, profiling a recent trade in which using the underlying stock instead of options made for much more favorable odds.

Options as a trading instrument offer you a tremendous variety of choices. From spreads to straddles to strangles, options give us all the ability to utilize our capital efficiently and manage our risk totally. But there are times when options may not be the best choice and simply trading the underlying offers the best odds of profiting from a position.

See related: Trade the Option or the Underlying?

Recently, I received an e-mail from a student that took our Options Trader course at our Stamford, CT center. He faced a delicate dilemma. He had the choice of either trading options on an underlying that had come up to resistance, or simply shorting the physical underlying itself. I wish to share with the reading audience some insights about his trade.

Below is the e-mail that I received from him:

“Josip, I’m having a hard time with risk/reward. To have positions that would generate a worthwhile gain, you have to risk an amount that could wreck an account. Ex: Feb 3 FLX entered a supply zone(14.67 to 14.90) and should retrace (14.35 at least)- Implied Volatility is in low 10%, To buy-to-open (BTO) Apr 12 $16 put would cost $1.52 (1.32 intrinsic value & -.70 Delta) With a rule to only risk 1% of my account, I would only be allowed 2 contracts. So, risking (1.52 x 2 =) 3.04 to make (.30 move @ .70 delta x 2=) less than .60, minus commissions. That’s a risk 5 to make 1 ratio; doesn’t really seem worth the risk. If I just shorted with stock - stop @ 14.90 - entry 14.70 - target 14.36 - that would be risk 1 to make 1.55 ratio. Any insight would be great.”

To recap what is in the above e-mail: The underlying is at resistance. The exact supply zone (SZ) extends from $14.67 to $14.90, which is about 20 cents. He is anticipating a short-term pullback due to the fact that this rally into the SZ would be the first re-test and is most likely to result in a failure to break out.

Such a set-up is a higher-probability trade, technically speaking. He also states that the implied volatility (IV) is low, which means that option traders should consider buying options (AKA “buying premium”).

When the IV is low, option premiums are underpriced, which is evident from his reference to the April 16 put, which has intrinsic value of $1.32 and a total premium cost of $1.52. Since this trader has provided me with the intrinsic value at $1.32 of the April 16 put, we are easily able to decrypt where the underlying was at the time of writing his e-mail ($16.00 - $1.32 = $14.68).

The put that he has selected was based on the Delta value of 70 cents, and his contract size (only two contracts) was properly done. Nevertheless, the fact that he expected a retracement to approximately $14.35 meant that the target was not attractive enough for the risk he would be taking with this particular trade using the Apr 16 put.

See related: Delta: King of All Option Greeks

He calculated that his risk was five times the reward and concluded that he would have the better risk/reward (1:1.55) had he traded the underlying by simply shorting it.

See related: Make Sure Risk/Reward Is on Your Side

My answer to him was a gentle reminder that in our Online Trading Academy Professional Trader class, we teach our students two simple rules. First, do not trade stocks that are trading below $15 because the average true range (ATR) on such products is not very great and it would take a long time for the trader to make a significant profit on a 15-dollar underlying.

Secondly, we discourage the students from an underlying that does not have average daily volume (ADV) of at least one million shares traded per session.

Having said that, I have seen a lot of students trading Bank of America (BAC), which is currently well below $15, so could it be that they are grocery-selecting from our Online Trading Academy rules? Out of all the USA tradable issues, is the underlying that he is addressing the best he could find? (That’s an open-ended question.)

If the volume is greater than one million, could he compromise and take a trade with the physical underlying? Yes, very possible. However, as he concluded himself, trading it with options would not make sense from a risk management viewpoint.

In conclusion, when we are presented with a similar situation (the choice between trading put options on an underlying that has come up to resistance, or simply shorting the physical underlying itself), we can always take the choice of trading the physical underlying.

Having options listed on an underlying does not mean anything else but that we, as traders, do have a choice to trade the underlying with options. Whether we choose to trade it with options is ultimately up to us. However, be aware of the fact that by trading the underlying, we do not have the very best and most optimum use of our capital. For either a long or short trade, brokers permit the use of margin.

Using options when possible, especially in spread trading, will give you an optimum use of your capital. Nevertheless, in the case of directional option trading, your exits need to be based on the value of the physical underlying rather than on your premium value of options, which we can only guesstimate with our mathematical calculations.

Have a great trading day and be aware of which trades should and should not be taken with options.

By Josip Causic, instructor, Online Trading Academy

Related Articles on OPTIONS