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May 18, 2017

Rules of Defined Risk Trades in Options

By:Sage Anderson

We ran a piece on the blog not too long ago that discussed strategy selection based on risk versus reward.

Today, we are going one step further and discussing some rules of thumb traders can use when deploying defined risk trades.

As a reminder, defined risk trades have clear maximum profit and loss potential, whereas undefined risk trades can theoretically produce unlimited profit and loss.

If you err toward the defined risk category of trading, a recent episode of Best Practices should be right up your alley.

Aside from the attractive risk characteristics of defined risk trades, there are other aspects of this approach that also benefit traders:

  • lower capital requirements

  • fixed maximum profit and loss

  • easily calculated probability of success

The reason defined risk trades possess these positives is because they are typically spreads, meaning that both long and short options are involved in the position. When the intent of the trade is to sell premium, that means that a wing (further out-of-the-money option) has been purchased to cap outsize losses.

The image below illustrates three types of defined risk trades (vertical spreads, iron condors, and iron flies) and the general structure of profit and loss expectations when selling these spreads. The blue line represents the tastytrade profit target on order entry:

It's worth spending some time reviewing the charts above to ensure you fully understand the risk inherent in each of the 3 trade types. If you have questions about what might be the best way of expressing a trade idea - in terms of trade strategy selection and structure - you can always reach out directly to the tastytrade team with any questions.

Another great part of this Best Practices episode are the guidelines discussed for vertical spreads. A vertical spread involves buying and selling options with the same expiration, but different strikes, in a 1:1 ratio.

For example, buying the October 60 calls against selling the October 65 calls in stock XYZ would be a debit vertical call spread. Doing the reverse, selling the 60 calls versus buying the 65 calls, would be a credit vertical spread.

When buying a debit call spread, the goal is to pay as little as possible of the five possible dollars that exists (in this case) between the two strikes. When selling the same spread, the goal would accordingly be to sell it for as much as possible.

However, because the market is theoretically "efficient," traders have to find a balance that fits their profile in terms of the debit or credit they are willing to accept. On Best Practices, the hosts discuss why they think at least a third of the total spread is required when selling credit vertical spreads.

In the above example, which had a $5 wide spread (60 and 65 calls), that would mean a trader would seek to collect at least $1.67 for this trade.

It's important to keep in mind that the duration of the trade, the relative implied volatility, and the perceived event risk in the underlying, may make that target moot - it could be too low or too high based on extenuating circumstances.

A great way to ensure you fully understand these types of trades, and to gain experience managing them, is to deploy them hypothetically and observe how they act. This is both easy to do and immensely valuable in terms of building out your skill set.

We also recommend reviewing the full episode of Best Practices dedicated to defined risk trade guidelines when your schedule allows.

If you have questions about the material please don't hesitate to reach out at Talking about trading is what we love to do!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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