They say "What gets measured, gets improved." And yet, all too often, traders don't actually measure the potential return and effectively match potential gains against the risk inherent in a trade.
To fully understand the risk-to-reward ratio, you need to be able to effectively predict the potential outcomes for a trade and measure the returns for the various outcomes.
So let's jump in and start exploring the risk-to-reward ratio as it applies to selling puts.
A Quick Overview of Selling Puts
If you're new to the put selling strategy, let's quickly explain how the process works.
We begin by selling a put contract on a stock that we would be willing to buy at a lower price. The put option obligates us to buy the stock if the price of the stock is below the put's strike price when the option expires. Puts are offered with various strike prices, so you can pick out a contract with a buy price that is close to what you would be willing to pay for the stock.
For selling this put, we are paid a "premium." This payment represents compensation for the obligation we are assuming and is the primary way that we generate income through the strategy.
If the stock remains above the strike price, we get to keep the premium. If the stock trades below the strike price, we are obligated to buy the stock -- 100 shares for every put contract that we sell.
Calculating the Potential Return
In order to get an idea of our potential reward for the trade, we need to calculate a nominal return on capital. This gives us a reference point so we know how the strategy stacks up to other investment opportunities -- specifically those designed to generate income.
The problem with analyzing the put selling strategy is that we are receiving capital initially for selling the puts, but we are not making a traditional investment where we can easily calculate the return based off the amount of capital allocated.
However, there is a solution for this. Remember, when we sell a put contract, we are obligated to buy shares at the strike price if the stock drops below this level. So from a capital allocation perspective, we need to be able to allocate capital toward buying the stock should our obligation be assigned.
To determine our rate of return, we can divide the income received from selling the put contract by the amount of capital we would need to set aside to buy the stock. Keep in mind that you are receiving a certain amount of capital from selling the put, so you can deduct this amount from the capital being set aside to get the actual amount of original capital that is potentially coming out of your account.
Once you divide the premium received by the adjusted amount of capital set aside, you are left with a nominal potential return for selling the put contract. This return takes place over the amount of time between when the put contract is sold to when it expires.
The amount of return will vary greatly, depending on how long until expiration, how volatile the stock is and where interest rates are, among other variables. For the majority of my put selling trades, we like to typically sell contracts that will expire in four to eight weeks, and we can usually expect to generate a return between 1.5% and 3.5% on the trade.
Putting the Return Into Context
Once we have the nominal rate of return calculated, it is best to annualize the number to see how much income you could generate if you made this trade continually throughout the year. This is an important step because generating a return of 3% means nothing without the context of time. You could compare your 3% return to a dividend stock with a yield of 4.5% and not be able to effectively determine which is better.
A standard industry practice is to take the nominal return, divide it by the number of calendar days the trade will take, and then multiply by 365 (the number of days in a year).
So, for instance, if our trade is expected to generate a return of 3% over the course of 55 days, we would take 3% and divide it by 55, and then multiply it by 365 to get an approximate annualized gain of 19.9%. Now this trade looks much more impressive than the dividend stock with an annual yield of 4.5%.
Of course, there's no guarantee that you will be able to find a similar trade to reinvest your capital in when the current put contract expires, but this is a way to get a general idea of what your annualized returns would be.
Analyzing Return in Light of Risk
The calculation we have discussed is based on the best-case scenario for the strategy. If our puts are not assigned, we keep the option premium with no strings attached and move on to the next trade.
But what happens if the puts are assigned and we are obligated to buy the shares? This introduces a whole new level of risk that we must account for.
I'll talk about how to measure the amount of risk in a trade, how to determine appropriate stop points and how to analyze whether a trade is worthwhile considering the risk-to-reward scenario in upcoming articles.