The 3 Advantages of Undefined-Risk Strategies
The 3 Advantages of Undefined-Risk Strategies
They offer a high probability of success, unfiltered exposure to the Greeks and easy adjustment
- Undefined-risk options strategies always yield higher probabilities of success than defined-risk strategies.
- You get unfiltered exposures to the Greeks with undefined-risk options strategies, such as negative vega and positive theta.
- Defined-risk strategies are difficult and clunky to adjust over time, whereas undefined-risk strategies are much easier to adjust.
Naturally, defined-risk strategies are attractive because your overall risk in the trade is fixed over the life of the position. But that safety net comes with several disadvantages not found with undefined-risk positions.
Here are three advantages that undefined-risk strategies have over defined-risk strategies:
1. Higher probabilities
First, undefined-risk strategies always have higher probabilities of success relative to a defined-risk strategy around the same strikes in the same stock. This has to be the case because otherwise there would be little incentive to ever go naked on a position.
Still, the differences in probabilities on a short put vs. a short put spread, for example, can be significant and add up over time.
By not buying the leg that would define your risk, you’re increasing the credit collected on the trade. This added credit leads to wider break-even points on the trade, which in turn, equates to a higher probability of success.
2. Unfiltered Greek exposure
Second, undefined-risk positions give you unfiltered exposure to the Greeks, such as positive theta and negative vega. This is beneficial because as premium sellers, we want to take advantage of volatility’s tendency to contract and the time decay from the passage of time.
When you enter a short-premium, defined-risk trade, however, you have an equal number of long options covering your short options. These long options end up diluting the Greek exposure you have with your short options. As a result, you don’t end up with nearly the short vega or long theta you would have with an undefined-risk position.
3. Easier adjustments
Third, undefined-risk strategies are much easier to manage and adjust over time, relative to defined-risk strategies. Having only short options in the strategy (i.e. short strangle), or at least having more short options than long options (i.e. ratio spread or jade lizard), enables you to collect additional extrinsic value whenever you want to roll out and extend duration.
This is not the case with defined-risk strategies, which often require a debit to add duration to a strategy that has moved against you. Paying a debit to roll defined-risk strategies isn’t something we normally do because any debits you might pay end up increasing your risk and decreasing your return on that defined-risk position.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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