When Option Reward Doesn't Match Risk

07/30/2012 9:00 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Dan Passarelli explains why option traders must always be watchful of the time to expiration.

Several groups of option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or failure of movement in price of the underlying. Examples of such strategies include naked option sales and vertical spreads.

As the positions “mature” by virtue of various combinations of changes or lack of change in these three primal forces, the initial risk-reward calculus often changes dramatically. The successful trader with a proper options education is aware of these changes, because the risk to extract the last bit of potential profit is often dramatically out of proportion to the magnitude of the profit he seeks to capture.

Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller on Apple (AAPL). First, a quick look at the daily chart:

chart
Click to Enlarge

This trader has chosen to write out-of-the-money puts, the August $510 strike, on AAPL, which currently trades at $570 in this example. His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and August expiration.

For taking the risk of writing these puts, his account receives a credit of $1 and margin is encumbered based on SEC rules. The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As August expiration approaches, the stock remains at the $570 level and the market price of the puts he has sold decreases as a result of time (theta) decay. As the price of the puts decreases and the profits increase, the risk-reward increases. As the price declines below the often used 20% re-evaluation benchmark of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial, and may no longer be appropriate given the reward.

The experienced options trader in such trades often finds the opportunities to deploy capital in other trades to be much more attractive than to remain in the existing position.

Dan Passarelli can be found at MarketTaker.com.

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