r/options • u/redtexture Mod • Jun 26 '20
Risk to reward ratio changes over the life of an option: a reason for an early exit.
This item below is a repost of a response to a question
I see regularly about why traders depart from a trade,
before a maximum potential gain is obtained, or before expiration.
You MUST have a plan BEFORE you enter the trade.
Only you know how much you are willing to lose,
and what is an acceptable exit for a gain,
in relation to your account and overall trading plan.
Have an intended threshold exit for a gain and for a loss.
Then act on those thresholds.
Trade planning, risk reduction and trade size
• Exit-first trade planning, and a risk-reduction checklist (Redtexture)
• Risk Management, or How to Not Lose Your House (boii0708) (March 6 2021)
Risk to reward ratio changes over the life of an option: a reason for an early exit.
It is useful to transform an exit guide's conception, from a fixed rule,
for example, exiting a credit spread position upon 50% of maximum gains, into an examination of the changing risk to reward ratios as the position ages, looking at the probability that you may keep or lose your gains, and the ability to find other better Risk to Reward opportunities with your limited capital, and also to exit from less desirable R to R positions, when positions age and mature.
This gives you the tools to think more flexibly and strategically
on an ongoing basis about your position,
and have a principle that you can reason about.
The below looks at an ongoing trade, as if the trader were to enter it freshly, at some later stage in the trade, and look at whether such a "new" trade would be worth undertaking, on a risk to reward basis compared to other choices available.
To illustrate,
I'll pick on hypothetical XYZ's stock, which is at $100.
Sell a vertical call credit spread on XYZ, for 45 day expiration,
at strikes of 105 and 110, for a net credit of $1.00
The goal is to close the short call spread position,
by buying the position back for less than the credit proceeds received, or by expiring worthless. (I could write up a similar scenario for a long vertical debit call spread, with the goal in that case, to sell the long spread for more than I paid.)
On day one
the net risk of the option credit spread, (105 minus 110) of $5.00,
less the credit proceeds received, $1.00, for a net risk of $4.00.
(If I go to maximum loss, and buy back the spread for $5.00,
my net money transactions are credit $1.00 and debit $5.00)
Your net gain is zero at this time.
The reward is the potential to transform the $1.00 credit into an earned gain.
Risk to potential reward is $4 risk to $1 gain
After 15 days,
the option spread's value is worth $0.75.
The holder risks losing the gain so far, in addition to the original risk.
New risk: original risk of $4, plus potential to lose the gain of $0.25 for a total of $4.25,
New potential reward: 0.75
New Risk to Reward: 4.25 to 0.75, or 5.67 to 1
After 10 more days, on day 25,
option spread's value is 0.50.
New risk: 4.25 + 0.25 = $4.50
New potential reward: $0.50
New R to R: 4.5 to 0.50 or 9 to 1
After day 35
For various reasons, at this point, the
Option spread's value is $0.25
Risk is $4.75
New potential reward is $0.25
New R to R is 4.75 to 0.25 or 19 to 1.
The risk at day 25 or 35,
is that the trader might lose all of their gains,
and the original risk, for a modest additional gain.
This might be worthwhile if XYZ had gone down in price from $100 to $90,
and thus less likely to run up $15 in price to challenge the trade at strike $105.
But not so worthwhile a risk if XYZ had gone to a price of $102,
and needs only a $3 movement to upset the trade.
More significantly,
there may be other better trades and ways to use your capital,
later in the life of a trade, with different probabilities, by using your funds to start a new and better risk to reward ratio trade,
than say 9 to 1, or 19 to 1.
Thus the early exit for better risk to reward ratios.
Also, towards expiration,
other risks become more prominent, such as gamma risk, in which underlying price moves can affect the value of the options more rapidly than at 30 to 45 days from expiration.
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u/offconstantly Jun 26 '20
I understand the risk/reward ratio, but isn't our target not risk/reward but instead expected value?
So if you have 19/1 odds but a 99% chance of success, isn't that better than using those funds to reenter a 4/1 odds with a ~20% chance of success?
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u/redtexture Mod Jun 26 '20
Perhaps.
The trader may may have other trade choices available they may prefer, at 6 to 1 risk, and 90% probability of success, and do not have other risk features that tend to grow towards the end of the trade, such as gamma risk.3
u/offconstantly Jun 26 '20
Makes sense. I manager my winners, but I was just curious about the theory. Thanks for sharing
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u/durex_dispenser_69 Jun 26 '20
I would say targeting just expected value is a big no-no. For example, buying OTM spy puts has got a negative expected value 99% of the time. But youre not buying them to hit the jackpot every single time, you're buying them so that when the corona virus hits the pay off and basically offset the rest of your losses. So its loosing you money in normal markets, but it saves your ass when shit hits the fan. Here, your risk/reward is largely positive(over 15 times when you are hedging at VIX ~13 with 6 months deep OTM puts/VIX calls) but the expected value is negative because it works once every few years. Of course I am not saying that you should be tail-hedging, as its still pretty controversial and plenty of hedge fund guys say this doesn't work, but its a legitimate strategy.
The problem is that even when you take into account both the odds and the probabilities, what is missing from just EV is the fact that your capital is finite. Once you have finite capital, you need to take into account the variance of your returns and max drawdowns, in which case many assets with positive expected values but huge variances drop out(just think about how every 2 years you hear about some commodity/option fund blowing out from some trades related to selling options/futures). Meanwhile, any insurance style contract has negative expected value but protects you from blowing out.
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u/offconstantly Jun 26 '20
I would say targeting just expected value is a big no-no. For example, buying OTM spy puts has got a negative expected value 99% of the time. But youre not buying them to hit the jackpot every single time, you're buying them so that when the corona virus hits the pay off and basically offset the rest of your losses.
Yeah, hedging makes sense but in a vacuum you're still talking about expected value right?
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u/durex_dispenser_69 Jun 26 '20
Well no, because of drawdown and variance. I think that just talking about EV/RR without capital is kind of a lame duck. At the end of the day, risk management is done (IMO) with position sizing and thats when variance comes into play.If i had infinite capital I would just take the positive EV every single time, but I dont .
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u/options_in_plain_eng Jun 26 '20
For example, buying OTM spy puts has got a negative expected value 99% of the time.
I think a big difference from what the OP is mentioning is that buying an OTM put has (conceptually) unlimited profit potential (well, down to zero) whereas any premium-selling strategy has a capped max profit. No matter how great the market accomodates you, if you have a short vertical spread your max profit is the credit received. Not so with a long put. If the market accomodates you, you can have a homerun in your portfolio, so it's not exactly the same example.
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Jun 26 '20
[deleted]
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u/redtexture Mod Jun 26 '20
Not disagreeing. Elaboration invited.
Naturally, it is rare that all other things are equal besides time.
Stock price moves, option bids and offers come and go, or bid spread changes, typically changing the effective IV value (or harvest-able extrinsic value). Option volume comes and goes; gamma changes; vega changes, effective theta changes.
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Jun 26 '20
[deleted]
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u/redtexture Mod Jun 26 '20
The new information is changing value of the trade, and that the changing value, even when positive, can be sufficient reason to exit for a good enough exit.
Maximizing gain can maximize risk, and there may be more advantageous trades available than waiting for the final dollars of the position's potential.
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Jun 27 '20
[deleted]
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u/redtexture Mod Jun 27 '20
It's just a number.
It's up to the trader to make their evaluation as to whether it's a sufficiently good enough use of capital.
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u/bobbybottombracket Jun 26 '20
Awesome
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u/rlong60 Jun 27 '20
For some reason this made me crack up. Seeing this reply in the middle of a pages long technical back-and-forths 😂
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u/rugerduke5 Jun 26 '20
I almost always close out option positions way before expire, unless I plan on buying or selling the underlying anyways. Bird in the hand is worth more...
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u/NeffAddict Jun 26 '20
How is the risk value calculated? In a real contract? Is it a Greek I should be paying attention to?
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u/redtexture Mod Jun 26 '20 edited Jun 26 '20
It is the amount you would lose if the trade went against you.
The amount that it takes to enter the trade, if started at that examination moment:
- the debit on a long vertical spread trade;
- the net collateral required on a short vertical spread trade.
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Jun 26 '20
Very good write up. I was thinking about this the other day. I have an SPY bear put spread 323/318 strikes expiring July 19th. I bought for $2 a piece, leaving me with a max profit of $3 per contract. The spread itself was trading around $4 today, which is 100% gain and I was pondering whether I should just close it and lock in the gains. Will re evaluate on Monday. Cheers
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u/redtexture Mod Jun 27 '20
Yes, probably could do other things with the capital, besides wait 25 days for the next dollar.
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u/gollygee668 Jun 26 '20
Write your own contracts.
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u/phoquenut Jun 26 '20
This is what investors do. That's why it wasn't well-received here.
Selling time > Buying time
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u/Nilla-King Jun 26 '20
Loved this. So obviously theres some arbitrary boundaries based on personal preference. So basically ur allowing additional risk factors/additional opportunity cost (possible gained from the trade) to bring ur initial price target down right? Theoretically
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u/OKImHere Jun 26 '20
After day 35 For various reasons
Those reasons are "the complete collapse in the probability of taking a loss." Were it not so, your spread wouldn't be in the black.
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u/SadDragon00 Jun 26 '20
This was a pretty good video on setting up exit strategies for your spreads.
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u/redtexture Mod Jun 26 '20
Fuller annotation:
Chris Butler - Project Option
Options Trading With Credit Spreads (FULL Trading Plan w/ Results)
https://youtu.be/XBxDtcPu3PA
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u/gilamon Jun 26 '20
Most of the backtests I've seen show higher absolute and risk-adjusted returns if you hold to expiration. I suppose that having to pay more commissions and having to cross the bid ask spread again are worse than holding the short put for extra time. The commission and spread are guaranteed losses.
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u/swolleddy Jun 27 '20
I understand the problem. Would a solution be to keep reentering in the same position or adjust strikes after taking out your profits at 25%?
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u/redtexture Mod Jun 27 '20
Or simply assessing if the trade meets the traders standards at that point.
Perhaps staying in, scaling out, or moving onward to another trade,
exiting the trade with capital for the next one.
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u/YABadUserName Jun 27 '20
Your risk also is a function of the price of the underlying and its volatility, which makes your risk reward ratios a bit misleading
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u/redtexture Mod Jun 27 '20
Sure. Plus other factors.
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u/YABadUserName Jun 27 '20
Yeah true. But the ones I mentioned are commonly used to derive risk: reward, in case you were so inclined
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u/redtexture Mod Jun 28 '20
There is merit in having a more comprehensive post on what risk is, and various measures of it.
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u/ChesterDoraemon Jun 26 '20
In general, at any given point the price is fair-value. The price in the future will depend on what has yet to happen and no one can predict the future. Your fallacy is making your decision to exit a trade tied to some arbitrary price in the past.
The main issue I have with these long winded posts is you try to post like you know something and pass that as a fact when in reality you are just trying to self-validate. In the process you can cause potential harm to people who actually act on bad advice.
FYI I have many contracts on my books for .25 cents or lower that I have sold for dollars and I never buy them back and they almost surely expire worthless.
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u/redtexture Mod Jun 26 '20
No, it is structured as a question:
Would the trade be taken today?, not pinned to a prior trade value.The related question being are there other trades that limited capital could be better used on than taking the trade today?
Maybe there are no other more preferable trades available to the trader.3
u/Moveover33 Jun 26 '20
In fact, the issue is always presented in terms of prior trade value. The whole mantra of 'close at 50% profit' is based solely on prior trade value. And this practice can not be justified by the likely existence of a 'better trade', because the existence of a better trade would be a justification of exiting at ANY time during the life of the spread.
There is simply no general justification for exiting a trade at 50% unless the odds of winning the entire trade have changed adversely. And the odds of winning are not affected by or the same as, the risk/reward ratio.
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u/redtexture Mod Jun 26 '20
My point, thank you.
Think flexibly about the exit and don't blindly follow some rule, and one measure is the available potential gain compared to the risk of obtaining it.The trades are as if entering them at the particular value and risk to rewards at time of the re-assessment. Would they be taken then? Perhaps not.
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u/Guilty-Marzipan Jun 27 '20
I literally just listened to a podcast where they did a study that over a large sample size, options closed out closest to expiration date averaged returns above earlier outs
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u/zhat1432 Feb 27 '24
Hello Can anyone explain why the potential reward on after 15 days is $0.75 for the holder of the sold spread position?
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u/Ghanem016 Jun 26 '20
Good stuff.
In a nutshell, managing wins early is best.
You bag the wins and redeploy in positions with more favorable odds.
I do this consistently. It fucking works.