How To Evaluate Risk And Reward With Put Options
In previous articles, we've made the case for why you should consider options as a part of your overall investing strategy. We've broadly outlined different strategies (such as selling put options), defined various terms, and have even showed you how to determine your potential return for trades.
But no discussion of any trading strategy is complete without looking at the potential risk you are undertaking. So today, let's briefly discuss how to evaluate the underlying risk in a put selling trade, which will then help us evaluate whether the trade is worth taking.
What Type of Loss is Possible?
To effectively gauge our risk, we need to figure out what our maximum probable loss is for the trade. Since we are selling puts, which obligates us to buy the stock at a specified price point (the strike price) if it falls below that level, we can technically say that our risk is that the stock will go to zero -- leaving us with a total loss from our purchase price.
Of course, the chance of the stock actually going to zero while we hold the put contract is very low, and evaluating our return based on the prospect of a total loss isn't very helpful in determining how attractive the trade actually is.
Instead of looking at the "stock goes to zero" scenario, we find that it is much more helpful to determine a support point on the chart or from a fundamental review of the company. This support point should represent the absolute low price we could see if the stock is healthy. In other words, if the stock breaks below this point, something is wrong and we need to close our position.
For instance, we may sell a forward-month $30 put against a stock we like that is currently trading at $31. Let's say the stock has established a support area near $27, so we may assume it is "healthy" provided that it remains above $26.50. If this support level is breached, then we will close my position and take a loss.
Now we need to determine how much of a loss our account would take if this support point is broken and we are forced to buy our puts back to close. Obviously, it is impossible to know exactly what these puts will be priced at if the stock trades to $26.50, but we can come up with a pretty close estimate by looking at current put contracts that are $3 to $4 in the money.
If the puts that are $3 in the money are trading near $3.50, and the puts that are $4 in the money are trading near $4.30, then taking an average of the two, we can logically assume that if we cover our puts when they are $3.50 in the money, we can expect to pay roughly $3.90 to close the position.
Note: There are a couple of issues to account for here. First, the put premium is likely to be higher if the stock is trading down because this increases the implied volatility for the option contracts. However, time decay (explained here) will likely help to offset any increase in the volatility premium. So our back-of-the-envelope estimate for our exit price should still be very close.
Keep in mind, if we are forced to buy our puts back at $3.90, this does not mean that we will take a $3.90 loss on the trade. After all, we received a premium payment when we sold the puts in the first place. For example, if we received $1.25 for selling these puts ($125 per contract, which controls 100 shares), our actual net loss will only be $2.65 per share.
The last step is to then take that potential loss of $2.65 per share, or $265 per contract, and divide it by the amount of capital that we were required to set aside for the trade in the first place. In our example, buying 100 shares of stock at the $30 strike price would cost $3,000, so our percentage loss would be 8.8%.
You may be surprised to find that the potential loss could actually be more than our expected return. In this example, out expected return would be 4.2% ($125 on $3,000 -- see article on calculating profit return).
What Constitutes A 'Good' Risk/Reward Trade
A trade that has a higher potential loss than its expected return is not automatically disqualified as an income opportunity. We still need to determine the probability that this trade will turn out to be profitable.
For instance, if our potential gain is $1 per share and our potential loss is $2 per share, we would need to see a better than 66% probability of success for the trade to make sense. If this trade had an estimated 80% success rate, then we could safely say that the trade is worth taking after considering both the reward and risk components. The probability of success is determined by an option's delta. We covered specifically how delta relates to selling puts in this article.
Of course, whenever we enter a trade in our account, we are dealing with imperfect information. This means that we must make our best estimates in terms of our potential loss, our probability of success, and even where option prices may be under particular circumstances.
Still, even with imperfect information, it is helpful to have a basic structure for evaluating trades in order to increase our probability of success and evaluate which trades represent the best opportunities.
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