Managing Risk with Options

Risk levels are different for calls and for puts on the short side. The timing of a strategy and choices made determine the actual market risks to which they are exposed. For example, a basic covered call strategy is deemed “safe” or conservative. However, if the basis of the stock is $39 and a covered call is opened with a 35 strike and with premium of only one point, the risk is considerable.Exercise creates an automatic net capital loss of $300 (four points between strike and the higher basis, minus one point for the option premium received). This is clearly high risk strategy, notably because the premium is small compared to the negative point spread between strike and basis.

A covered call strategy is likely to be high risk if the underlying is a highly volatile company. If the market value declines rapidly, it will result in a paper loss. For example, I bought 100 shares at $39 and sold a covered call with a 40 strike, receiving a premium of 5. In this case, the breakeven on the downside is $34 ($39 basis minus 5 points received for selling the option). If the stock declines below that level, the net outcome is in the loss. On the upside, exercise produces a profit of $600 ($500 received for selling the call, plus one point capital gain). So this situation presents a limited profit on the upside with potentially unlimited loss on the downside. Covered calls do not guarantee profits.

Risk even for uncovered calls, may be quite low. Focus on calls expiring within a month or less reduces risk due to time decay during option’s final month. From there, uncovered calls can be selected based on a combined analysis of implied volatility and probability. The uncovered call opened without concern for time or proximity but only to augment the premium level is far more likely to represent a very high risk strategy.

The uncovered put contains much less risk than the uncovered call. The short put is less risky because risk are finite. An underlying price can only fall so far, at first glance drops to zero but the more specific risk level should be dropped from strike of the put and the tangible book value per share minus the premium received for selling the put.

For short spreads and straddles, the maximum loss is the ITM exercise level, minus the premium received for opening the position. Maximum gain is limited to the premium received and this is realized only when options end up OTM at ATM, or are closed prior to expiration at a profit.

Another key risk which I will like to highlight is Lost Opportunity Risk which comes in two varieties. First is the opportunity to take up positions that is lost when your entire equity and margin are at maximum. If your portfolio is full of paper loss, you lose opportunities because you are unable to move when those opportunities arise. Second definition relates to covered call writing, if the underlying price rises far above the strike, the short call is exercised and the trade loses the opportunity that would have resulted by just owning the underlying. 

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