The inevitable question every options trader faces: “Is it high risk?”
In evaluating a strategy, traders tend to put the risk label on everything. However, it examining the attributes that increase or decrease risk, the test should not be based on a trade’s attributes but on the situation.
The chart of Amazon.com is used here as an example of how this works. On June 9, price peaked and then declined from about $1,010 down all the way to nearly $920 at one point on that big-volume day. Early on during this session, with price nicely placed in the upper proximity of the Bollinger Bands, a seemingly low-risk strategy was the uncovered call expiring one week later.
Depending on the strike selected, this “low-risk” strategy might have met the standard, or it could have ended up very high-risk. If the strike was picked between 860 and 980, exposure was severe on the entry date once price declined. A strike below that level would have been safe.
This points out that depending on the situation, a strike may be high-risk or low-risk. The key to mitigating risk exposure is to establish a comfortable buffer zone between the current price and the strike. On the other side on the trade, note the highlighted consecutive long shadows. This pointed to a high likelihood that price was bottomed out. This was not only reassuring to traders with open short puts, but for others as well. Timing was perfect to enter a long call based on the lower shadows and proximity of price to the lower Bollinger Band as well.
Confirmation of this timing was seen in the volume spike on Friday, June 16. The price trend was bullish, confirmed by the spike.
In all of these situations, it was not the attributes of the option, but the condition prevailing at the time that defined risk levels. Amazon.com is a good example of this distinction because it has exhibited a tendency to move rapidly and then to retrace just as rapidly. Thus, this stock is excellent for options-based swing trades, as long as the current conditions are clear.
On the other hand, some high-risk strategies could be quite safe. For example, once price reached a plateau at about $1,010, timing would have been perfect to open an uncovered call. This is widely thought of as a high-risk strategy but, as subsequent price behavior revealed, in this situation, an uncovered call could have been very profitable. At the time, however, there were no clear signals other than the momentary resistance price set at the top of the trend. Because this was visible only in hindsight, any swing trader with typical risk tolerance would avoid exposure through an uncovered call – especially based on Amazon’s strong price history in recent months. During the six months in the chart, price moved upward about 280 points, in only six months. In that situation, writing an uncovered call remains high-risk even though timing would have been perfect.
In conclusion it appears evident that placing a label on every instance of a trade and its attributes can be misleading. First, check the situation (proximity of price to top of bottom of the range, level of volatility, and strength of reversal or continuation signals) as a first test of risk, and then decide on a strategy that firs your individual risk tolerance.