What's Low Risk and What's High?

06/05/2015 8:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Risk is not simply a cut-and-dry concept, but one that involves many variables, so option trader Michael Thomsett, of ThomsettOptions.com, offers several examples of option strategies often thought of as high risk that may actually turn out to be low risk and vice versa.

Here is a new way to think about investment risk, especially for conservative trading. The idea of conservative can mean different things to different people; so I offer a definition of this concept. Any low risk investment with above-market average return is a Conservative Investment.

In the past, I always thought of risk in terms of specific products, especially when it came to options. For example, a covered call is conservative but an uncovered call is high risk. A debit spread is conservative but a credit spread is high-risk.

Even after being a trader and investor for more than 35 years, I now realize that risk is not based on the attributes of the strategy, but on timing and placement. So for options, for example, it is not enough to stick with a specific strategy. You really need to look at a broad range of attributes including volatility, probability, and even fundamental and technical analysis.

Some examples of strategies often thought of as high risk that may not be:

1. Naked puts. The uncovered put has the same market risk as the covered call; but it is more flexible. You can roll out of a loss position with more flexibility than the covered call, because you do not have to worry about a capital loss as you do with depreciated stock in a covered call. You do not get dividends and you have to post 100% collateral, compared to a margin cost of 50% of stock in a covered call. But the strategy is worth another look for a stock with exceptional support and growth potential.

2. Naked calls. Considered the ultimate risky trade, is this always the case? Consider the situation with a stock that has risen sharply right after a positive earnings surprise. A short-term reversal is likely after exaggerated price spikes. If the naked call is at-the-money and due to expire within one week, the risk is minimal. By monitoring the situation carefully, you are likely to end up with a profit. If the call moves in-the-money, it can be rolled forward indefinitely to avoid exercise. Consider the weekly options for this defensive roll. So the naked call strategy works best very close to expiration. Also avoid this strategy when ex-dividend date comes up before expiration; the period right before this is the most likely time for early exercise.

Some examples of strategies thought of as low risk that might be high risk:

1. Covered calls. This is a favorite among traders, but there may be considerable risks. For example, if the stock price falls, the call will expire worthless, but then what? You may not be able to write another covered call without risking a capital loss if and when exercised. If the call is written with the wrong strike, you could set up a profit on the call but a larger loss on the stock. Covered call writing makes sense when you are willing to risk exercise, when the dividend is exceptional and will be earned before expiration, and when all outcomes, including exercise, are going to be profitable.

2. Basic long positions. Time puts you at a great disadvantage. The closer to expiration, the faster the time delay, and the farther from expiration, the higher the cost. It is possible to see a long position move in the money, only to be offset by declining time value. The result could be a deterioration in value and ultimate loss. The best time to buy long options is right after an earnings surprise with the expected exaggerated price spike; the option is timed to exploit the correction that usually follows, so these will be one to three day trades.

The equation of conservative versus risky is not a black and white one, but involves many variables. My conclusion is that you cannot assign labels to a strategy without first understanding the circumstances of the moment. Risk is itself a variable in deciding which options to buy or sell.

By Michael Thomsett of ThomsettOptions.com

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