By now most tastytraders are well aware that a statistics-based approach such as trading volatility relies on a high number of occurrences.
A good example of why can be illustrated through the 50-50 chance associated with flipping a coin. If someone flips a coin tens times, there's a small chance that one could end up with "10 tails" or "10 heads." However, as the number of occurrences increases, the results will assuredly converge toward an equal number of both "heads" and "tails."
The same can be said for high probability options strategies, as recently highlighted on an episode of The Skinny on Options series. The purpose of this episode of the show was to demonstrate why a higher number of occurrences gives us a better chance at success.
Interestingly, there are methods by which traders can increase the number of occurrences (i.e. trades) and also theoretically reduce risk in their portfolios. While that may sound like "voodoo magic" or "too good to be true,” - it isn’t.
The method of increasing occurrences while simultaneously reducing risk is discussed on a recent episode of Tasty Bites, and certainly worth a few moments of your time. If you can believe it, such an approach can also theoretically help increase your return on capital.
The key to this enigma is related to the varying margin requirements of “naked options” versus so-called "defined-risk" positions. A defined-risk trade, such as a vertical spread, has known maximum losses, whereas a naked short option has the theoretical potential for unlimited losses.
Due to this important distinction, brokerage firms usually require less capital to be put up against defined risk positions versus naked option positions. The graphic below helps illustrate this concept:
As you can see in the example above, the result a defined-risk approach is therefore threefold. First, the known risk (vs. unknown risk) inherent in such a position requires less absolute capital. That means the potential return on capital is also theoretically higher than an equivalent naked position (also pictured above).
Secondly, the lowered margin requirement also frees up capital that can be deployed in additional positions - allowing us to increase our number of occurrences. Finally, defined-risk positions also reduce overall exposure in our portfolio (removing the overhang of potential “unlimited losses”) - another factor that allows us to sleep more soundly at night.
For traders seeking to optimize the rewards of potential returns, with the risks of potential losses, following the “defined-risk” path may therefore be preferred. The added bonus is that reduced margin requirements also allows traders to deploy more positions (if they so choose).
We hope you’ll take the time to review the complete episode of Tasty Bites focusing on the balancing act between risk, returns, and occurrences when your schedule allows. To learn more about defined risk positions we also recommend this installment of Options Jive: Mechanics of Defined Risk Trades.
If you have any questions about the topics covered in this post, please leave us a message in the space below, or reach out directly by emailing email@example.com at your convenience.
We look forward to hearing from you!
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.