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Short Options Positions – When the Risk Outweighs the Reward

Key Points
  • There are two very important ways to evaluate a trade:

    1. The amount you could lose compared to the amount you could earn
    2. The probability of profit compared to the probability of loss
  • Investing always involves some level of risk, but when the remaining potential profit is very small relative to the remaining loss potential, it may be smart to close the position out.

Two of the most important ways to evaluate a trade are to consider the amount of money at risk (max loss) versus the amount of money you could make (max gain); and the second is to consider the probability of earning a profit versus the probability of incurring a loss.

Amount you could lose vs. amount you could earn

This is sometimes also called the risk-to-reward ratio. When considered alone, a trade with a low risk-to-reward ratio might initially seem like a good investment, but that is only true if the probability of earning a profit is also high. In other words, if the amount that can be lost is very low, that does you little good if you incur that loss most of the time. Likewise, if the amount that can be earned is very high, that does you little good if you almost never earn that profit.

The justification some traders make for engaging in such low probability trades, is similar to that which motivates those who buy lottery tickets; the probability of winning may be extremely small, but it is not zero. Most of the time, the risk associated with these strategies is limited to the initial cost to establish them, so there is virtually no incentive to reduce that risk by closing the positions early.

Probability of a profit vs. the probability of a loss

This is sometimes also called the profit-to-loss ratio. When considered alone, a trade with a high profit-to-loss ratio might seem like a good investment, but that is only true if the amount of profit that can be earned, is also high. In other words, if the amount that can be earned is very low, that does you little good if a single loss could wipe out many profitable trades. Likewise, if the amount that can be lost is very high, you may find yourself in a position whose remaining risk is no longer justified by the remaining potential payoff.

While the probability of loss may be extremely low, it is not zero. And just like the passage of the Brexit referendum and the election of Donald Trump have shown us recently, no matter how unexpected, if the probability of something happening is greater than zero, it can happen.

As an example, consider an out-of-the-money short put strategy on an up-trending stock. This strategy involves selling time (Theta) whereby the probability of profit is usually much higher than the probability of loss. In most cases, if the underlying price remains relatively stable, the strategy will be profitable. However, even when this strategy performs as intended, there is a point at which the additional income that could be earned from holding the positions until expiration, may not justify the potential risk if something goes wrong.

As a service to our options traders, Schwab now allows you to close any short options position executed at a nickel ($0.05) or less, with no online commission charges. To take the emotion out of trading, you can even enter a GTC (good-‘til-cancelled) limit order at $.05 to take advantage of this program.

Let’s take a closer look at the short put example:

Let’s assume it is July 2017, XYZ is trading at 108.70, and you established the following position:

Sell 1 XYZ 10/20/2017 107 put @ 2.50
Net credit = 2.50 ($250)

This option is initially $1.70 out-of-the-money but it is worth $2.50 because it has approximately 3 months before it expires. XYZ would have to be trading below 107 at expiration for this option to be in-the-money. If this option eventually expires worthless, a profit of $250 (excluding commissions) would be earned. If you are assigned, you would be forced to purchase 100 shares of XYZ at 107. At that time the market price of XYZ could be substantially lower than 107, resulting in an immediate loss of significantly more than $250.

Assume XYZ is trading at $108.00 two days before expiration, and this put option has declined in value to an asking price of just $0.05. While it is unlikely that XYZ will decrease in price by more than $1.00 in the next 2 trading days, it is not impossible. Since the maximum profit that could be earned on the option is $250, and closing it out today would allow you to capture $245 (98% of the maximum), the no commission buy-back program will allow you to eliminate the risk associated with maintaining this short option for the final two days. While the risk of being assigned and having to purchase stock that you do not want to purchase is low, it is probably not justified given the additional profit potential of only $5.00.

Now let’s take a look at another example involving a credit put spread:

Let’s assume it is August 2017, XYZ is trading at 108.70, and you establish the following positions:

Buy 1 XYZ 11/17/2017 100 put @ 0.20
Sell 1 XYZ 11/17/2017 107 put @ 2.50
Net credit = 2.30 ($230)

The option you sold is initially $1.70 out-of-the-money but it is worth $2.50 because it has approximately 3 months before it expires. The option you bought is initially $8.70 out-of-the-money but it is worth $0.20 because it also has approximately 3 months before it expires.

XYZ would have to be trading below 107 at expiration for the short option to be in-the-money, and below 100 for the long option to be in-the-money. If both options eventually expire worthless, a profit of $230 (excluding commissions) would be earned. If both options go in-the-money and are assigned, you would incur a loss of $470 ($700 loss minus the $230 initial credit). If XYZ is between 100 and 107 at expiration a loss of up to a maximum of $470 could be incurred.

Assume XYZ is trading at $108.00 two days before expiration, and the put option you sold has declined in value to an asking price of just $0.05. While it is unlikely that XYZ will decrease in price by more than $1.00 in the next 2 trading days, it is not impossible. Since the maximum profit that could be earned on this spread is $230, and closing out the short leg today would allow you to capture $225 (98% of the maximum), the no commission buy-back program will allow you to eliminate the risk associated with maintaining the short option for the final two days. While the risk of being assigned and having to purchase stock that you do not want to purchase is low, it is probably not justified given the additional profit potential of only $5.00.

While we only discussed two examples above, this offer can be applied to any short option position whether it is a single stand-alone strategy such as naked calls, naked puts or CSEPs (cash secured equity puts), or part of a multi-leg strategy such as covered calls, covered puts, short straddles, short strangles short butterflies, short condors, iron butterflies, iron condors, or any kind of ratio spread, or combo trade; the size of the trade or the amount of the risk doesn’t matter. Since closing a short option position(s) at a net debit always involves a reduction in risk, we don’t want commission costs to be a barrier. To qualify, trades must be:

  • An option trade
  • A closing transaction 
  • A net debit 
  • Executed at a price of $0.05 or less

 

Bottom line

Trading always involves some level of risk, but when the remaining potential profit is very small relative to the remaining loss potential, even if the probability of loss is extremely low, it’s time to close out; and now you can do that with no online commission charges.

"Consider Closing Short Options Commission-free
Consider Closing Short Options Commission-free
Common Pitfalls for New Options Traders
Common Pitfalls For New Options Traders

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Important Disclosures

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