Anticipating the Likely Return on Options
You should not decide to use multiple contracts solely to reduce your costs, but that is one way to amend your calculation of profitability for a particular strategy.
In evaluating strategies, you will also benefit by calculating the expected return. This is the probability of several different outcomes, averaged to create a "most likely" outcome, and this is useful in determining whether a particular strategy is worth the risk.
Smart Investor TipReturn calculations are rather inflexible when based on single contracts. While examples using only one option clarify possible outcomes, in practice you have much greater flexibility and lower trading costs by trading in multiple contract increments.
ExampleGreat Expectations: You are considering writing a covered call on stock you own. The stock recently rallied so you see a covered call as a way of taking profits in the event the stock falls. If the covered call is exercised, you are also willing to sell your stock at the striking price. You can receive 5 ($500) for a call expiring in three months that is today at the money. Because you expect the stock's price to retreat, this seems like a good plan. Expected return is based on a series of several possible outcomes:
- The stock will continue to rise and the call will be exercised. You think there is a 25 percent chance that this will happen. In this case, your overall profit (including only call premium) would be 100 percent.
- The stock will remain close to the striking price of the option but will not go in the money. You would wait for the option to lose half its value and then buy to close and take the net profit. For this, you believe there is only a 10 percent chance. Your profit in this case would be 50 percent (based only on the call's premium).
- The stock will retreat back to previous trading levels and remain there, in which case you expect the option's premium to retreat to 2.5 or less. In that case, you would probably close the position and take your profits. This would also create a 50 percent profit. You believe there is a 40 percent chance this will occur.
- The stock will retreat below previous trading levels and the option premium will fall drastically. In this outcome, you would be inclined to let the call expire worthless. This would create a 100 percent profit. You believe there is a 25 percent chance that this will happen.
Given these possible outcomes, expected return would consist of calculating the likely range of outcomes:
|A||100 %||25 %||25 %|
|Total||100 %||71 %|
The expected return in this case is 71 percent. This is also based on the recognition of covered call writing as having good profit potential, but this example is limited to analysis of the option premium. It does not take into account the risks involving the stock. You may also want to think about the possibilities of the stock's rising far above the striking price (meaning the covered call strategy involves a lost opportunity) or falls below. That means that, if the stock's price were to retreat and remain lower, you would have lost the chance to sell at a profit when the price per share had been higher. So expected return might be further extended to include an evaluation of outcomes based on stock profit or loss as well. Exercise of a covered call at a striking price above original basis is invariably profitable. But a paper loss is a risk to consider, just as lost opportunity in the event of exercise.
You can take analysis of this type to any extent you desire. But at some point, options traders are going to need to make decisions and not spend excessive time on highly detailed theories about likely outcomes. Hopefully, before investing in any options positions, you will appreciate the range of risks as well as the potential profit or loss. But most options traders soon discover that they can take analysis only so far; eventually, they need to act, and often decisions have to be made quickly to take advantage of ever-changing price conditions.
Smart Investor TipExpected return is useful for identifying a range of likely outcomes. In situations where expected return is minimal given the range of risk, this calculation can be used to decide to not proceed.
Every options trader needs to calculate a practical and accurate outcome to the potential trades involved. Everything works out well on paper, of course; but when you consider the cost of transactions, interest on margin balances, and income taxes, you quickly realize that these are elements of risk. No one can predict every possible outcome; but you can improve your percentages in all forms of options trading by identifying and performing reliable forms of likely returns. The calculations do not need to be complicated, but they do need to be consistent and accurate.
By Michael C. Thomsett