Choosing which option strategy to use is one of the most difficult decisions for an option trader.  Some seminar gurus tout covered calls as the best strategy because it reduces risk but still allows for a profit.  Others suggest straddles, because you can make money whether the market is going up or down.  If you've traded options for a while, you no doubt have heard many others.

But the unfortunate truth is that no single strategy works in all types of markets.  In order to really understand options trading, you need to understand that each option strategy comes with its own set of risks and rewards.  Anyone who says that a particular strategy is superior to another is only telling you that they have a preference for a particular risk-reward profile.  But it may not be best strategy for current market conditions or for your personal risk preference. 

Be careful of anyone that tells you otherwise.  They either do not fully understand options, or are trying to sell you something.  Those that claim one strategy is the best for all markets usually focus on one aspect of the strategy – either the risk or reward side – and completely neglect the counterpart.

The best option strategy is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying.  That is why we try to give you a full understanding of each option strategy in our educational articles, including what market conditions they work best in, and a complete description of the risk versus reward profile.  This allows you to learn how to dissect a position into its component parts, see if you are willing to accept the associated risks, and how you can further tailor them to match your needs.  Don't spend your time looking for the single best option strategy.  It doesn't exist.

Using the Risk/Reward Graphs in MarketVue

To fully understand the relationships between risk and reward with options, you need to look at profit and loss diagrams.  If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where one of the strategies performs better.  The decision you have to make is how likely that scenario is that gives you the best risk/reward profile.

Let’s use an example of comparing two trades, a simple call purchase versus a bull call spread.  To access the online analysis tools in OptionVue research, you first need to be logged in, and then simply click on the “MarketVue” available on the far left of every page (circled in red in the example below) 

Then click on the first choice along the left side, “Quotes Display”.  This will bring up your fully customizable quotes display, where you keep those assets that you want to follow:

For this example I will use Ocean Energy (Symbol: OEI).  To the right of the symbol are four choices: Chart, Volty, Matrix, and News.  We already discussed the first two choices (Chart and Volty) in the previous article: The Online Charting Tools in MarketVue.  Now we want to click on the word Matrix, which brings up a window with all the information on Ocean Energy, including the full option chain and current (15 minute delayed) quotes:

At the top of the Matrix is the information for stock itself.  Below that are all the current options available.  Each column shows the expiration month (which days to expiration in brackets), while each row shows a specific strike price.  The call options are in the top half of the Matrix, the puts in the bottom half.  If you are not sure what each number represents, simply click on the Legend button to bring up a quick cheat sheet that shows what each represents:

Notice that in Ocean Energy Matrix above, I entered the number 7 in the Trade field of the February 20 Calls.  The program automatically put in an At Price ($1.40 in this case) that I should be able to buy these calls at.  Now that a prospective trade has been entered, all you need to do is click the Analyze button near the top to bring up the risk graph of the trade:

Each graphic analysis shows the profit/loss on the vertical axis, with the various prices of the underlying asset (the stock price of Ocean Energy in this case) on the horizontal axis.  Each of the colored lines represents a different point in time.  The red line is today, the blue line shows the trade on the expiration day, and the green line show the trade halfway between today and expiration.  The profit and loss tables at the bottom, including all the Greeks, are color-coded to match their respective lines.

On the left is a summary of the trade that shows the expiration date, that no change (0%) in volatility is being projected, and that the total capital required for this trade would be $980 (not including your commissions).  Below that, it shows the expected return (E.R) of the trade is $97, +/- $1,680.  The breakeven point of the trade (where you neither make nor lose any money by expiration day) is at $21.40.  Finally, it shows that the Probability of Profit (P.P.) for this trade is 35%.

Comparing Risk/Reward Between Trades

Let’s see how that compares to a bull call spread, keeping the amount of capital needed as close to the same as possible.  For $80 less ($900 total, although your commissions would likely be a little higher) I could buy 10 of the February 20 Calls, and sell 10 of the February 22.5 calls.  The risk graph of this vertical debit spread (often called a bull call spread) looks like this:

Looking at the summary to the left, you can see the expected return is slightly lower (only $9), but with a much smaller variance of $1,170.  The breakeven point is lower, at $20.90, and the probability of profit is slightly higher (39%).  What makes one trade better than the other?

The answer to that lies in your tolerance for risk, as well as your future expectations for this stock.  The long call position is much more sensitive to changes in the stock price.  If you think the stock will quickly move up in price, you are probably better off with the long call position.  The spread takes a longer time to develop, and you only reach the full profit potential near expiration day.  On expiration day, you would make more money with the spread position if the stock was between $20 and $23.50.  It the stock ends above $23.50, you would be better with the long call position.

That is the reward side.  But what about your risk?  Looking at the line representing expiration day, there is little difference between the two trades if the stock ends below $20.  Both positions will expire worthless, and you will lose all your money.  But as I mentioned before, the long call position is more sensitive to changes in the stock price, and that works both ways.  If the stock were to quickly drop in price, you will lose more money with the long call position than the spread.

Conclusion

Pick any two strategies and look at their profit and loss diagrams.  You will always see that one strategy is better over a given range of stock prices.  Try switching one position from long to short.  Try changing strike prices.  You will soon see that it does not matter; one strategy cannot dominate another for all stock prices.

Strategies come in all shapes and sizes.  Try looking through the various educational articles on option strategies that were written by our President, Len Yates, to gain a better understanding of each one.  Different strategies alter the risk-reward relationship, and it is up to the trader to decide which is best.

Don’t be afraid to alter a strategy to meet your risk preferences – that is what option trading is all about.  While we give recommendations each day within this site, that is what we consider ”the best” at the time, but our best uses a fairly aggressive acceptance of risk.  Accepting someone else’s strategy as the best means you also accept his risk tolerances.  If that is not in sync with your own preferences, you will not be able to relax and enjoy your trading, and will eventually learn that the expensive way that no strategy is superior to another.