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Consistent income trading options: Trade risk vs. capital at risk

Trade Risk and Capital at Risk
Trade Risk and Capital at Risk
Photo by Dave Kotinsky/Getty Images

In our quest to understand trading options for income, the topic of this article is the distinction and importance between trade risk and capital at risk. I am addressing this issue because of a conversation with another trader who recently blew out a large portion of his account (over 70%) recently and he described how he trades (Put credit spreads vs. naked Puts was the focal point).

This trader's approach in selecting a stock had nothing to do with the POP (probability of profit) in selecting the short strike, and had everything to do with how many option contracts his account could handle. The big loss for this trader occurred with Apple (AAPL), and apparently he took advantage of the Put credit spread to nearly maximize the amount of contracts allowable. For this trader, the risk of this trade was simply the capital at risk; there was no appreciation for the probabilities of the trade.

After having experienced such a large loss, the lesson this trader learned was that Put credit spreads can be very risky as opposed to naked Puts. Why? Because the margin requirement on the naked (short) Put is so high that it limits your ability to overtrade. Huh? There's clearly a disconnect between trade risk and capital at risk, since credit spreads (defined risk) are far less risky than naked positions (undefined risk).

Let me first differentiate between trade risk and capital at risk. Trade risk is the probability of losing one-cent or more (or the opposite of POP) while capital at risk is the maximum potential loss of the trade. With the former, we consider the POP we are comfortable with based on market expectations. For example, if I believe that the bull market will continue forward, then the POP selected for a Put credit spread might be 84% (or 1 SD, or standard deviation); that's a risk level of 16% (100% - 84%). If the market appears to be in consolidation with some strong down moves (as occurred recently), then I might select a POP of 97.5% (or 2 SDs); a risk level of 2.5%. I am adjusting my POP based on my expectations of near-term market moves.

When dealing with the latter (capital at risk), we consider the risk of ruin; that is, if we trade too large, then we are likely to blow out our account after one or two bad trades. A general guideline for money management is that we should not risk more than 3% of our account size on any one trade; this allows us to trade many different assets (stocks, for example) concurrently without concern that several trades going bad will have a severe impact on our account. The next guideline is portfolio management, which limits our total investment to around 50% of our account size. Since I trade predominantly the SPX (the S&P 500 index) which offers inherent diversification (this index reflects the price actions of the 500 largest capitalized stocks), I simply apply portfolio management guidelines to each weekly trade.

So, if we are going to trade Put credit spreads, how do we chose between different underlyings (stocks, indexes, etc.)? The basic answer is: for a given POP, select the underlying that offers the highest premium; or for a given premium, select the underlying that offers the highest POP. There are other practical considerations as well: trade only underlyings with liquid option chains (volume in the hundreds to thousands for the strikes being considered); trade only high cost underlyings (like Apple, SPX, etc.) which offer better premiums; and trade underlyings in which IV Rank (implied volatility percentile) is high (over 50%) which improves premium and reduces risk.

In conclusion, both trade risk and capital at risk are important concepts. Understanding the difference and following the guidelines of monetary and portfolio management will lead to better trading outcomes.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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