Is Option Risk Worth the Reward?

Read the title of this article before you go any further. Smart traders should consider asking themselves this when entering a trade and, in my opinion, it should be documented in your trading plan. In addition, option traders should consider repeating this mantra in the first part, middle of and toward the end of each trade.

When I am talking to option traders, I always point out that they should consider multiple exits for profit and loss. I cannot tell you how much this has improved my own option trading. There is not a perfect management plan out there, I promise. Having several exits just makes sense.

You have to be a risk manager first and then a trader second to be successful on a consistent basis over the long haul. But why do I and why should you consider multiple exits? The answer to me is simple and it all boils down to removing risk. I see too many traders who hold positions because they expect to earn the maximum profit or close to it. Now don’t get me wrong, there are some positions that exceed our expectations, and the maximum profit is earned sooner than was expected. Who doesn’t love trades like that? Unfortunately, those profitable trades are not as common as those that take their time becoming profitable or of course end up losing. Let’s go through an example that may better illustrate my point.

In class on a recent Monday, we were discussed buying a SPDR S&P 500 ETF (SPY) Jul-16 435/440 bull call spread with expiration that Friday. At the time AAPL was trading in the $436 area, and the spread was going to cost about 2.30. This is the maximum risk on this position, and it would be realized if the stock closed at $435 or lower at expiration, which was at the end of the week. The maximum profit is the difference between the strikes (440 – 435) minus the cost of the spread, which in this case was 2.70 (5 – 2.30). That would be earned if AAPL closed at $440 or higher at expiration. I suggested looking for a profit of 20% of the max profit, which would have been about 0.55 (2.70 X 0.20). I said consider putting a GTC Sell Limit order out there for 2.85 (2.30 + 0.55) for half the position and moving up the stop loss on the remaining contacts to breakeven at 2.30.

On Wednesday, the SPY moved higher (close to $438) and the spread’s value moved past 2.85, meaning the sell order for profit would have triggered. For some option traders, that might not have been a big enough profit to consider selling some of their position (me not being one of them). But now look at the current risk/reward scenario. By Thursday’s close, the SPY closed below $435 meaning the breakeven stop loss would have triggered too. A 20% profit was realized on half the position with the other half trailing out at breakeven.

Being a risk manager throughout the life of your position is imperative for your potential success. Consider removing risk in a modest and timely fashion and sleeping better at night.

John Kmiecik, Market Taker Mentoring

Trader Education