Options as a Strategic Investment

One will commonly hear or read the following “rule of thumb” for trading:Only trade positions with potential profits of at least three times the potential loss.This sounds like a reasonable rule, risking a little to make a lot. However, it ignores the probabilities involved. Buying a lottery ticket for $1 to potentially make one million dollars certainly meets this criterion for a good trade. But we intuitively know that the odds against us winning are astronomical. This paper will define risk/reward ratios, define the concept of expected value, and begin to explore the relevance of these concepts to success in trading strategies.Risk/Reward RatiosIf we are considering an investment where the maximum gain we can expect is $100 and the maximum loss that we may incur is $500, we would compute a risk/reward ratio of 500/100 or 5:1 (five to one) . This is a high risk/reward ratio in that we stand to lose a large amount compared to the maximum gain. The trading rule above of “potential profits of three times the potential losses”, would result in a small risk/reward ratio of 1:3.Expected ValueThe probabilities of the various outcomes of a proposed investment are often overlooked. When someone tells you an investment will return 300%, but doesn’t tell you the probability of success, you are missing critical information necessary to make a decision about that investment. When one accounts for the probability of the profitable outcome, one computes the expected value, sometimes called a risk adjusted return on investment.For example, let’s assume we are considering a covered call on IBM and the called out return is 4% for IBM closing over $90. If we were to determine the probability of IBM closing over $90 is 65%, then we would say that the expected return or risk adjusted return is 2.6% (0.65 x 4%). We can take this analysis one step further by accounting for the probability of loss. Using the same IBM covered call, let’s assume we have a stop loss order entered that we believe will take us out of the trade with a 8% maximum loss. Now our expected return has two terms:Expected Return = (probability of gain) x (maximum gain) – (probability of loss) x (maximum loss), or,Expected Return = (0.65)(4) – (0.35)(8) = (2.6) – (2.8) = -0.2%Therefore, if we were to place this trade many times, our expected return, based on the probabilities of gain or loss, would be a net loss of 0.2%. One could improve this strategy by either improving the probability of success or tightening the stop loss to reduce the maximum loss.High Probability TradesTrading strategies can be positioned in a variety of ways resulting in a broad range of risk/reward ratios. One extreme category may be called the high probability trades, i.e., trades that have probabilities of success of 85-90%. One type of option spread strategy, known as the iron condor, can be positioned in such a way as to have an 85% probability of profit. On the surface, that sounds very attractive. However, the losses for these trades can be quite large, even though their occurrence is unlikely. For example, a typical iron condor might be characterized as having an 85% probability of achieving a 19% return but a 100% loss with a 15% probability of occurrence. The expected return:Expected Return = (0.85)(19) – (0.15)(100) = 1.2%Or the calculation can be done with the dollar amounts. The 19% gain could correspond to a $1,600 gain and a maximum loss of $8,400. The expected return is:Expected Return = (0.85)(1600) – (0.15)(8400) = 1360 – 1260 = $100Therefore, trading this strategy over time and many trades is going to be close to break even, and probably a loser after trading commissions are included. Let’s consider the opposite style of trading and then draw some conclusions.Low Probability TradesLow probability trades are akin to the lottery ticket, i.e., the maximum loss is small, but the probability of success is also extremely small. There is a category of option spread known as “far out of the money vertical spreads”. The basic characteristic of this trade is a small maximum loss, but with a high probability of incurring that loss. An example might be a vertical spread that only cost $130 to establish, but could potentially return $870. Since the maximum loss is $130 with a probability of success of 12.5% and the maximum profit is $870, the potential gain is 669%, so the expected return is:Expected Return = (0.125)(669) – (0.875)(100) = 83.6 – 87.5 = -3.9%or,Expected Return = (0.125)(870) – (0.875)(130) = 109 – 114 = -$5So, the expected values of this low probability strategy result in small losses over time.ConclusionsTrading strategies come in all sizes and shapes to suit anyone’s style and risk preferences. But the reality is that none of these strategies have an inherent advantage. Some trading education firms and authors of trading books will often claim that they have found the holy grail of trading and have the “best” trading strategy. Each trading strategy has its own set of advantages and disadvantages. In addition, if each trading strategy was applied in a blind, “ put it on and let it run” methodology, the net results would be very similar: near break even or a small loser over time. However, the pattern of the results would be quite different. For the examples above, the high probability trading strategy would have many small positive gains throughout the year, but would be expected to have a small number of large losses that wipe out the gains. Whereas the low probability trading strategy would have a small number of large gains, but those gains would be wiped out by a large number of small losses.Therefore, one must manage the trade in such a way as to develop a probabilistic edge. The best analogy is a Las Vegas casino. If you analyze any of the games played in the casino, you will see that the odds favor the casino. The casino has a small probabilistic advantage, so the owners know that over time, they will come out winners. In stock and options trading, one must understand the probabilities and have developed a trading system that gives the trader a positive edge. You want to learn to trade like the casino, not the gambler at the tables.

Many people think of options trading as very risky and suitable only for the “high rollers”. This article briefly surveys how options can be used in conservative financial portfolios to boost the income from your stocks.For the purposes of this article, let’s assume we have a stock portfolio of conservative stocks, e.g., IBM, GE, etc. We may be realizing moderate price appreciation of the order of 5% annually plus dividend yields of 3%, for total portfolio growth of 8 to 10% annually. One easy way to boost our annual gains without increasing our downside risk is to sell call options against our stock holdings. This is known as a Covered Call.A Covered Call is created by selling the appropriate number of call options against stock in our portfolio. Let’s assume we own 500 shares of shares of IBM and IBM closed at $104.69 on May 28, 2009. We are concerned the stock may trade sideways or only slightly upward for the next few weeks. We could sell 5 contracts of the June $105 call options for $2.35, or $235 per contract. This brings $1,175 into our account. If IBM closes at any price less than $105 on June 19, the calls we sold expire worthless and we keep the $1,175 we received and this represents a 2.2% return on our investment in IBM. However, if IBM rallies to any price above $105 by June 19, our stock will be “called away”, i.e., whoever holds those calls that we sold, will exercise them to buy our 500 shares of stock for $105/share. In this case, our account balance will stand at $105,000 plus the $1,175 we received for the calls or $106,175. This represents a gain of 2.5% for about three weeks.There are always trade-offs for any investment strategy and the covered call is no exception. The downside of the covered call strategy, illustrated by this example, is that we gave up any stock price appreciation beyond $105. In return for surrendering that upside potential, we were paid $1,175, or 2.2%. If we are using the covered call strategy with conservative stocks like IBM, it is unlikely that we will see big moves in the stock price very often. Most months will see our call options expire worthless and we will take in additional cash as the stock price moves sideways or slightly upward. Adding one to two per cent income per month to our conservative stock portfolio adds up over the year.Some traders use the covered call to increase the income from a conservative stock portfolio when the market seems a little slow. Others select and buy stocks with the express purpose of selling calls against those positions. In either case, the position should have a stop loss contingency order placed with the broker to protect the downside. The covered call strategy can be expected to yield about 2-3% per month. Of course, every trade will not be a winner, so it would be foolish to project annualized returns of 24-36%, but one can use this strategy to boost the income from a conservative stock portfolio.One forewarning is in order when using covered calls with blue chip, dividend-paying stocks.  If the call options you sold are in-the-money, or ITM, as you approach expiration, the calls are rarely exercised early if there is more than $0.05 to $0.10 of time value left in the option premium. However, if the stock is about to go ex-dividend, the call may be exercised early to take advantage of receiving the dividend. The dividend paid to the stockholder may outweigh the time value lost upon exercise.The Covered Call is a conservative strategy for boosting the income of a blue chip stock portfolio. However, the disadvantage of this strategy is the sacrifice of the gains above the price of the call option sold. Selling calls against highly volatile stocks would be a much different strategy than our example with IBM. A Google (GOOG) covered call would be much more aggressive; when GOOG is quiet and trading within a range, we would make a nice return, but when GOOG makes one of its $100 runs within a few weeks, as it did recently, we would be caught with a $10 or $20 return instead of the $100 return. When covered calls are used in conservative stock portfolios, boosted returns of an additional 5% to 10% per year are reasonable expectations, and this can be done without increasing the downside risk.