I hope everybody has enjoyed there Saturday. I was stuck inside working the whole time and well this is still working so nothing changed haha. I hope you guys have been following me the last few weeks. I am shock at the progress I have made thus far. I have generated roughly 15% returns in 3 weeks. I know this isn’t and shouldn’t be sustainable but I will keep on trying.
Now remember last time we talked about selling premium and how we have more chances to win and make money because we don’t know where the market or a stock will go. We then discussed what happens when we sell an option and how there is unlimited risk for that trade. This article will discuss how we can define our risks.
How can we cap our unlimited downside and if we can, what do we give up in order to do it. Here is the scenario we will reference. Stock ABC is trading for $100. We are bearish on the company so we are going to sell the $105 call for $300.. There is also a $106 call trading at $280 and we have a $110 call trading for $130.
If we just sold the $105 call for $300, our max profit is $300 but our max loss is infinite if the stock shoots all the way up. We do not want to be out thousands of dollars. The way we can define our risks here is to buy a option to cap our risk. How does this work? Let’s say that in addition to selling the $105 call for $300, we also bought the $106 call for $280. So by selling and buying both of these options, we only received a $20 credit. By selling the call naked, we were able to collect $300. Why are we giving up $280?
The reason we do this is to cap our max loss. In return, we make less money. So how does the scenario work out to cap our max loss? Remember that our short $105 call goes against us as the stock goes up and pasts our $105 strike price. For each $1 the stock goes above $105, we must pay out $100.
So at $110, we must pay (110 – 105) * 100 = $500. We did collect in a credit of $300 so we are down $200.
In the scenario above, what happens with our $106 call. Since we are long the option, we make money as the stock goes up and past $106. For each $1 above $106, we make $100. So if the stock is at $110, we make ($110 – $106) * 100 = $400. We did have to buy this option for $280 so we made a total profit of $120. The end result of both of these trades is a loss of $80 or to better put it, the difference in our short and long strike less the credit received. When we buy an option that is further out of our short option, we cap our max loss and define our risk.
The max profit we make by shorting an option and buying an option is the credit received. We only collected $20 above. The max loss we have is the difference in strike price less the credit. ($106 – $105) *100 – $20 for a total of $80. At the end of the day, if the stock is less than $105.20, we will be a winner, but if the stock ends up at $110, $125 or even $1,000, we will lose no more than $80 because we bought the $106 call option.
This seems like a good idea and is one way to set a max loss in your head. In theory you could sell that $105 call and put in a stop loss but one thing you will realize with options is that for the most part, they will always test you and so you must be mechanical and adjust accordingly. Most trades will lose a little before they become a winner. A stock can go up $10 one day and just as easily drop down $15.
What if the scenario above, instead of buying the $106 call, we bought the $110 call for $130. We would be short the $105 and long the $110. From our example, the most we can lose here is $500. We received a credit of ($300-$130) = $170. Our max loss on this trade is $500 – $170 = $330. If you are going to define your risk, one thing that I always try to do and the people at tastytrade try to do is to sell these spreads for 1/3 the width of the strike. This gives us a high probability of success and limits our max loss to 2X the credit received. So in the scenario where we received $20 but our max loss was $80, our probability of success is about 80% of making at least $1 and max of $20. In the scenario where we buy the $110 call, our probability of success is around 67% but we could make $170. By defining your risks as well as determining how much credit you receive is up to your own risk tolerance. I try to increase make trades with 60-75% probability of success but there are times I am more or less aggressive depending on my perception of the market/stock.
This same scenario works for Puts as well. Now that you know what a vertical spread is, you now have all the tools needed to create all sorts of strategies such as iron condors, butterfly, jade lizards and put ratio spreads.
I don’t think I did a good job explaining everything here and might further touch on it at times but I hope we have answered some questions and concerns about selling options and the unlimited risks we originally had.