Not long after options became available, there were the seminars and the books and the systems that come with any new financial product. These things tend to come from ‘experts’ with opinions as to which option strategies are the best: Covered Calls are best because they have limited risk and unlimited profit potential; Naked Puts are better because you can earn premium income and set yourself up for buying the stock below current levels; Short Strangles are the best because they allow you to make money when the market is not moving at all.
If you’ve been trading options for a while, you no doubt have heard many others. But when you hear comments such as these, all you’re hearing are opinions of one person’s preference for a particular risk-reward profile. In order to really understand options trading, you need to understand that all options strategies come with their own sets of risks and rewards and the market will price them accordingly. Be careful of anyone telling you that a particular strategy is superior to another; they either do not fully understand options or are trying to sell you something.
The best option strategy is… the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying. The best strategy is also the one that makes the most of the current market environment.
This is the level of options trading knowledge a trader should have. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how to further tailor them to match your needs better. Don’t spend your time looking for the one superior options strategy; It doesn’t exist.
To fully understand the relationships between risk and reward with options, you can just look at payoff diagrams. If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where either strategy dominates.
For example, some elementary books on options will explain how call options are superior to owning the stock. So let’s look at this one.
Assume one of us buys a stock for $50 and another buys the $50 call for $0.80. We can plot the profit and loss at expiration for each position, and we will get the following diagram:
The trader who buys stock at $50 will make $2 profit if the stock is trading at $52. Likewise, if the stock is trading for $48, the trader will incur a $2 loss.
The call buyer will lose $0.80 if the stock is $50 or below and will break even if the stock is $50.80. At a stock price of $52, the $50 call buyer will make $1.20 profit (the call option will be worth $2 less cost of $0.80).
So the profit and loss from the stock is superior to the call option for smaller movement in the market. Additionally, the dollar return from owning the stock remains superior even as the stock rises and rises.
The downside of owning the stock is, firstly, if the market falls more than $0.80. Cent for cent this will lose money. Loss from the call option however is limited to the $0.80. Additionally, there is the cost of capital to consider. Buying the stock (unless on margin) will cost you the whole $50. The call cost just $0.80.
It should be evident that one strategy is not better than the other; it depends on your outlook of the stock and the amount of risk you are willing to accept.
The investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes the stock is heading higher, but doesn’t want the exposure to the downside, is better off buying the call. The tradeoff is that he will pay $0.80 for the stock instead of $50 and only be subjected to a $0.80 maximum loss. In return, the breakeven level is higher and the dollar profit will never be as great at the stock.
What about naked puts? They must be better than holding the underlying because it’s like getting paid to buy the underlying, right? This is what some argue, but it’s not always the case.
Let’s look at the profit and loss diagram in Eurodollar futures where we have (a) purchased the futures and (b) sold an at-the-money put for 22.5pts:
Again, in some areas of the chart the long futures position dominates, and in others it does not. The long futures position is better for prices above 98.725. With the futures above here, the long position will realize increasing profits, while the naked put will profit only by the premium received from the sale of the put.
However, if the futures price is below 98.725, the naked put is the better strategy. Below 98.73, the naked put will always make more money or lose less.
Pick any two strategies and look at their profit and loss diagrams. You will always see that any one strategy will dominate over a given range of underlying prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all prices.
Strategies come in all shapes and sizes. Now you should have a better understanding of why. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best. Do not be afraid to alter the strategy to meet your taste. That is what option trading is all about. If you accept somebody’s strategy as the “best”, you are, by default, accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will eventually learn the expensive way, that no strategy is superior to another.