Options are risky investments not only because they create leverage but also because they take expertise level knowledge and/or experience to understand their behaviors. Once you understand the fundamentals of plain-vanilla options it becomes much easier to understand and anticipate behaviors of structured derivative products.
In this chapter we’re going to look at some of the risks and potential losses that may result from your structured option investments.
Before we elaborate on that it might be useful to revisit some of the different risk categories.
1. Directional risk: The risk that comes from underlying moving in an upwards, downwards or flat direction.
2. Volatility risk: The risks associated with underlying security’s volatility increasing or decreasing.
3. Liquidity risk: The risk of being able to buy or sell the components of the strategy, for instance: call option, short option or the underlying security itself.
Although covered call strategies cut down the risks tremendously compared to the naked call or put strategies, they still have a certain level of risk. It will be beneficial to understand and be aware of these risks for anyone who is interested in covered call investments.
1. Directional risk in covered calls: Covered calls don’t have a limited loss profile although profit is capped. (loss is theoretically limited with the whole price of underlying minus premium collected). This means they have a significant risk of the underlying price going down. Since it is a strategy that you would get involved with if you would like to keep the underlying asset, you would normally pick a stock that had sound fundamentals, historical track record, proven operation health, sustainable revenue growth etc. Some of the popular blue-chip stocks could be a good example of these traits such as: Apple and Amazon.
It is a very rare event for blue-chip stocks to diminish or go bust in a day, even less established stocks usually don’t normally lose all their value in a very short term. However, we must list the theoretical risks involved which is downside risk when it comes to covered calls.
Also, some of the industries that used to produce more blue-chip stocks historically are giving way to more innovative, technology-oriented industries and disruptive companies. This is a normal process for the market cycle except the change is happening at an accelerated speed.
2. Volatility risk in covered calls: If we recall the components of a covered call, they are a short call option and a long underlying security. Call or put option prices increase and decrease parallel to the volatility of the underlying. Since we sell call options in covered call strategy if the volatility was to increase during the life of the option that would mean it gets more expensive in the market. And if we wanted to cover our short call position it would be more expensive to replace them. But in a scenario where you wait until the end of the term volatility doesn’t have an effect by itself. If the volatility fell during the option’s life, it creates an opportunity to cover the short call position early if the investor wanted since the call options will be priced cheaper in the market now. They would have this price fall effect also from the time decay since the option loses time value as days pass. This is the reason why covered call strategy can be such a lucrative and medium risk investment or income generation method if the investor is aware of the dynamics and technicalities of the strategy.
3. Liquidity risk in covered calls: Liquidity explains the degree of ease buying and selling a security. Most liquid assets can ben instantly bought and sold at a continuous market price. And if the asset is illiquid that means you might not be able to sell it easily when you become a seller. This might imply that you have to give significant discounts and/or wait for a long time before you match with a seller depending on the degree of illiquidity.
With covered calls, liquidity risk is small as you are buying an underlying and selling a call option. However, if the call options have odd terms and maturity dates it might have an illiquidity problem. Similarly, if the stock involved has a small cap and trading volume or belongs to a small country or an exotic exchange that is not very common you may or may not encounter liquidity problems. It is not very likely with a listed company that has options on it but still do your homework regarding this aspect of your strategy.
Covered Call Maximum Loss
Underlying Security losses – Short call premium
Covered Call Loss Scenario: Let’s make an example on Amazon stocks where the investor owns 100 AMZN and shorts a call option on the same asset as underlying. (Let’s say AMZN is trading at $1720 and the option costs $60 with 30 days to expiration and strike price of $1750) During the life of the option you have to hold the stock because otherwise your position would be a naked call. On the expiry date if the option expires worthless you realize your premium gains but let’s look at the loss side. If the underlying price falls all the way to $1000 in a crisis scenario, you would have lost $1720 – $1000 = $720 minus premium collected = ~$660
$660 is a big loss and it shows us that covered call is not much more risk averse than investing in stocks. However, it also seems slightly less risky since you collect option premium, and these serve as a loss buffer in a bad scenario making the losses smaller than they would normally be. Still, upcoming option strategies will provide more protection against potential maximum loss scenarios. (Excluding PMCC which is a replication of covered call strategy with less capital)
Also, in an extreme scenario where underlying was to go all the way to zero dollar per share your maximum loss would be stock entry price minus premium collected, so a loss bottom-line slightly less than the full stock price. (maximum loss scenario)
PMCC has very similar risk characteristics in some respects and also different risk characteristics in other respects. Most of these differences occur from the LEAP (long term deep in the money call option) component of the PMCC. Let’s look at those similarities and differences under relevant categories.
1. Directional risk in PMCCs: PMCCs have similar directional risks as the original covered call strategy since it aims to replicate its behaviors. If the underlying goes upward there is not much risk involved except the profit is capped. However, if the underlying is to go down, PMCC will start losing value from its LEAP (deep in the money long term option) component. Since the LEAP component here will likely be cheaper than the actual underlying itself, we can say that the nominal risk from underlying price going down is lower compared to the covered call strategy. However, if you entered a bigger PMCC position because it costs less than the covered call strategy than you might still incur same level of losses since you will lose more in terms of percentage.
2. Volatility risk in PMCCs: Volatility effects on a PMCC are more neutral since there is a long call and short call in the position compared to only 1 option in the covered call. So, the volatility effects will be more or less offset in the PMCC however, depending on the vega greek, there might still be some volatility exposure on the PMCC strategy.
3. Liquidity risk in PMCCs: PMCC has similar liquidity concerns as covered call but slightly bigger and that additional risk comes from the LEAP component. Since LEAP replicates the long stock component of a covered call strategy it is a long term, deep in the money call option with a very high delta. Sometimes, depending on the underlying and other features, such long-term options can have very limited liquidity and illiquid assets usually have very high bid-ask spreads as well. So, when structuring a PMCC strategy or having your investment manager do it, it is important to keep in mind the liquidity of the components involved, even more so than the covered call strategy when you’re dealing with the PMCCs.
PMCC Maximum Loss
Long call loss (LEAPS) – Short call premium
PMCC Loss Scenario: Since the only difference between PMCC and covered call is that PMCC uses deep in the money call options to decrease the capital intensity of the investment, loss profiles are also very similar, but since the invested capital is less, potential losses are also less than it would be compared to a covered call scenario.
Let’s say you invested in a PMCC structure where the long call option (LEAPS) costs $200 and the short call option costs $50. As the underlying price falls both call options will lose value. And on the expiry date if the underlying is below the strike of short call option it will expire worthless. However, LEAPS will also lose some value. Technically, maximum loss LEASPS can incur is its full price ($200) and loss will be that minus the premium collected. So, if the LEAPS is worth $150, loss will be $200 – $150 -$50 = 0.
If the LEAPS’ value goes all the way to 0, loss will be $200 – 0 – $50 = $150.
Iron condor is a very neutral strategy regarding its profit and loss profile. Both sides of the market, up or down, profits are capped, and losses are limited. However, you won’t be making profits either if the underlying price goes beyond a certain limit on both ends. Nevertheless, it is usually regarded as a less risky strategy than covered call or PMCC.
1. Directional risk in iron condors: Although limited there is a risk of losing money if the underlying price rises above a level and also if it falls below a certain level. So, there is a limited risk involved with iron condors directionally.
2. Volatility risk in iron condors: Similar to the PMCC, most of the volatility effects are expected to be offset since iron condor strategy involves 4 options position, 1 call and 1 put long and 1 call and 1 put short. Also, since the long and short options, for each call and put categories, have very similar characteristics the offset is going to be higher than the PMCC where LEAP option has very different greeks compared to the short call option in that strategy. Long story short, minimal to no direct volatility risk involved with iron condors.
3. Liquidity risk in iron condors: General option selling and buying dynamics apply to the iron condor strategy as well. However, since you are dealing with a set of 4 different
Iron Condor Maximum Loss
Difference in strike prices – net credit received
Iron Condor Loss Scenario: Iron condor is a limited loss capped profit strategy meaning your maximum loss will be limited by definition.
Vertical spreads resemble both covered call and iron condor in different perspectives and they are very risk averse products if the investor knows what they are doing.
Like covered calls, vertical spreads have a capped maximum profit profile on one end but there are two major differences. One, vertical spreads also have limited loss profile on the loss side and two, vertical spreads can have their profit profile on either side of the market depending on the type of the vertical spread (Bull or bear spreads).
1. Directional risk in vertical spreads: Vertical spread is not a very risky strategy and if your insight is directionally wrong then there is a limited loss potential with the vertical spread. However, if you enter huge positions and be on the wrong side you might still incur losses with this strategy.
2. Volatility risk in vertical spreads: Similar to iron condor and PMCC strategies, volatility effect is mostly expected to be balanced with vertical spreads since they also involve buying and selling of options which has offsetting effect on the total vega exposure of the portfolio.
3. Liquidity risk in vertical spreads: Just as other option trading strategies, option liquidity is an important aspect when structuring a vertical spread strategy and it will be useful to avoid very illiquid options with odd maturity dates or issuers as well as other nonstandard terms. This might also be a limiting factor regarding the underlying asset. Usually the lesser trading volume and popularity underlying has the lesser liquidity its options will have. It’s even impossible to find any issued options on some of the stocks that are not very well known.
Vertical Spread Maximum Loss
Bull Put / Bear Call:
High strike – low strike – net premium received
Bull Call / Bear Put:
Net premium paid
Another important point to mention regarding liquidity of options is that sometimes it is possible for market conditions to change and as the underlying assets move, option parameters can change greatly. Some deep out of money options can become at the money and some deep in the money options can lose their intrinsic value and become out of the money. Time value continuously decreases as well and after a while you might find your very popular option to become much less liquid than before. That’s why it’s important to understand the dynamic nature of the options and they often may require a close eye on them before, during and after you enter your investments. This might be one of the reasons why these potent and useful financial tools are usually at the hands of professionals.
Not all risks in finance world are about losing your money. There are also risks of restricting profits. In many structured option strategies, if you see a scenario of limited or reduced loss profile, this usually comes with the cost of capped profits. This usually means you are hedging your position by balancing the loss probabilities with sacrificing profit opportunities.
For instance, covered call and PMCC strategies are good examples of this phenomenon. When you are holding a stock that you favor for the long term, it might make sense to sell call options to make some extra profits on a flat market by collecting option premiums like a real investment professional. However, if a premature rally started for your underlying stock (which is probably not very unlikely since you are in favor of holding that stock long term at first place) that means you might lose all the potential upside since your short call position will cancel out the profits from the underlying price increase.
Above paragraph explains one of the reasons why structured option strategies require you to be on point with your mastery of market fundamentals as well as option fundamentals. A strategy like covered calls can be an amazing investment tool if you have an intuition of flat market and markets really stayed flat for a year or two while you are selling call options on your stock position and collecting low risk profits along the way. If you compare this ideal scenario with an investor who is only long in their favourite stock, they would be wasting their capital for years without any profit other than maybe dividends which can be equal to losing money to inflation. These are probably the main reasons why covered call strategies are usually pronounced to be perfect investment strategies to consider during low volatility times.
If we look at iron condors, again, we can see that upside potential is capped. This means after a certain level no matter what the underlying price increases to your strategy will not profit above a certain level. Of course, this comes with the benefits of limited loss profile. Meaning, also no matter how high or low underlying price goes your loss will be limited to a predefined number.
Vertical spreads bull or bear have similar trade-offs as the iron condor strategy except one side is profit and the other side is loss. Iron condor’s P&L profile is made possible by applying 2 spreads and 4 options total, while vertical spreads only employ 2 total options equaling 1 spread.
If you have very strong predictions that underlying security will move towards one side (up or down) vertical spreads can be the perfect strategy for you. (bull spread profits from upside movement and bear spread profits from downside movement, hence the names bull and bear.)
And your position is protected in the loss scenario as the loss is limited at a certain level. However, this privilege comes with the cost of capped profits. No matter how big the movement in your predicted direction, your profits will have a cap, and this might be hurtful in investing. It is for this reason investors should be aware of the consequences and pros and cons of these state of art strategies. If you accept the trade offs before you even enter your position it will help maintain a clear mindset and stay on top of your investments. Although easier said than done this point is a very strong aspect of successful investments, mastered by most of the successful investors and traders. There is not a shortage of academic and professional material explaining the behavioral economics and investment psychologies however, your own experience and reflections during this journey will be the real key element in achieving success and mastering powerful investment strategies.
Finally, rolling option positions can be a personal and subjective pursuit. Although there are common adjustments such as the ones explained in this chapter, it still depends on your personal insight and expectations regarding how to navigate changing time and market conditions. Adjustment is usually an attempt to either save a position that didn’t go according to the plan or improve a position’s characteristics and make things more relevant.
It’s always better to start testing the waters when you’re learning something new and gain expertise through smaller mistakes rather than devastating ones that might take a long time to recover and set you back. Although those are also usually the ones to contribute greatly to an investor’s perception and discipline as well as helping acquire seriousness and focus that’s usually needed in the investment world.
Here is a summary of a few important aspects of option adjustments:
– Adjustments are made to stay in the position, keep the position relevant or based on obligations.
– Always count in your rolling costs, such as broker commission, fees and spread width.
– If the position is seemingly hopeless it might be a good idea to accept that your initial market insight was wrong.
– Rolling can be the much-needed blood for a position but don’t always expect a miracle. It usually means something is going wrong or didn’t go as planned initially.
– Always have a solid understanding of what you’re doing and don’t leave it to chance with options and investment in general.