In trading, with practice, we become very good at discerning the risk that we are taking to enter a position. Collect $2 in premium for a $5-wide spread? The risk is $3. Paying $5 for an at-the-money option? The risk is what you paid.
But risk is not the only thing that you have to worry about in trading. You have to know when a risk turns into a danger.
What’s the difference between a risk and a danger?
Economist Elroy Dimson once said,
Risk is the fact that more things can happen, than will happen.
That is to say, we don’t know all the possibilities that could unfold in a particular scenario. Risk is the probability of loss that traders accept in exchange for a reward. Risk isn’t inherently bad or good, it just is. In trading, the only thing you have complete control over is risk management.
While a risk weighs the potential for a reward against a potential loss, a danger only exposes you to losses. To accept a danger is to accept a risk that carries little to no reward. Traders should seek to manage risk and eliminate dangers. But to do that, you first have to be able to identify the danger.
When risk becomes danger – Scenario #1
In order to spot potentially dangerous scenarios, you need to be proactive. That means knowing where your entry and exit points are before you enter a trade.
Let’s use a bullish call debit spread for example – consider a 100/105 vertical call spread that costs you $3.00 (risk) and has a maximum potential gain of $2.00 (reward). For the sake of the example, we’ll say the spread expires in two weeks.
Shown above is a graph depicting the expiration curve of the trade in blue, which indicates the spread value at option expiration. Alongside the blue line is the current curve of the trade in red, which indicates the value of the spread as the price of the underlying stock fluctuates throughout the life of the option.
At the outset of the trade you were risking $3.00 (60% of the maximum value) to make $2.00 (40% of the maximum value). But what happens if the entire spread goes in-the-money as the underlying stock moves up towards $120? This would lead the spread to gain most of its max potential value (as indicated by the separation between the red and blue lines at price point $120).
Will you manage the trade?
Shown below is a graph depicting the value of the spread if the above scenario takes place, and the underlying moves to $120 with two days remaining to expiration.
You can see the current curve converging with the expiration curve, lifting the value of your spread to $4.75. Remember, you initially risked $3.00 to initiate this trade.
So, has the risk-reward of the trade changed?
That’s right! It certainly has. Now your spread is risking $4.75, and you stand to gain a maximum reward of $0.25.
Professional traders don’t care about what the price they paid; all they care about is what the trade is worth now. If you paid $3.00 and the position is now worth $4.75, that’s $4.75 at risk.
Risk and reward are dynamic factors, meaning they are constantly in motion, flowing with other market factors. That brings us to the crux of our point. If you hold onto this trade…
Are you taking a RISK or are you in DANGER?
The answer, probably clear to you now, is that you’re putting your money in danger!
The value of your spread advanced from $3.00 to $4.75. You gained 35% of the max value in a little over a week. Why hold on for two more days for just $0.25 when anything could happen?
There are safer ways to make that 5%. If you still believe in the trade, it’s typically safer to roll out to a higher strike or later expiration. That allows you to take some profit off the table and reset your risk-reward ratio.
When risk becomes danger – Scenario #2
OK, that was an easy introduction. But what happens when the spread is larger or you own an option that has become deep in the money? How does risk become danger in those situations?
In our new example, we’ll again use a bullish call debit spread, except this time it’ll be a $100/$110 vertical spread. For the sake of this example, let’s assume the cost of entering the trade is $3.50.
What happens to the spread value if the trade moves to our upper (short) strike of $110 with 15 days left to expiration?
Looking at the graph above, this move would raise the total spread value to $7.70. Remember, the maximum potential value is $10.
So in total, you’re risking $7.70 to make $2.30, with more than two weeks to go. Are you in danger?
You might say no, that risking $7.70 to make $2.30 is adequate risk to take. And in that, you wouldn’t be wrong. However, in this situation, there may be a hidden danger.
To expose that danger, we’re going to need to think abstractly about the components that make up the spread we purchased.
To illustrate that, the above graph overlays the $100/$105 spread onto our initial diagram, which is a piece of the $100/$110 spread that we already own.
Take a closer look and you’ll see the danger is quite clear.
While the total value of the $100/$110 is $7.70, $4.90 of that premium comes from the $100/$105 spread. That means you’re holding onto a trade that is at 98% of its maximum value.
What do we call that? DANGER!
Rather than hold on to the trade for that final $0.10 (2% of the maximum value), a smart trader will roll this spread up to a $105/$110 spread by selling the $100 call and buying the $105 call, thereby realizing $4.90 in profit and leaving only $0.10 on the table.
The resulting trade? A $105/$110 call spread that risks $2.80 to make $2.20. By rolling up the strikes in this spread, you captured $4.90 in premium and are now risking 56% of the maximum spread value. Compare that to the 77% that you would be risking had you not managed the trade.
The bottom line
There’s no definitive line in the sand for what does and does not constitute a danger. It’s up to you to identify what risk/reward profile is most suitable for your portfolio and to manage your trades accordingly.
More important than whether you take profit at 90% of the maximum value or 98%, is that you do it consistently, and with discipline. Consistent strategies lead to consistent returns, and practicing discipline is what separates Market Rebels from the rest of the pack.
Interested in learning how you can use the power of unusual options activity to conquer the market? Click here to download our Insider’s Guide to Trading UOA.