How should traders utilize their Buying Power (BPR) to allocate capital between "defined risk" and "undefined risk" trades?
Higher risk for example is associated with greater probability of having a higher return and lower risk is associated with a greater probability of a smaller return. This is called the risk-return trade off.
As option traders, this risk-return trade off is obvious -- defined risk trades such as verticals have a well-defined profit versus loss, while an undefined risk trade such as a strangle or naked put has a larger possible loss, but on average the return makes up for the possibility for a larger loss.
So is there a general "rule of thumb" that we should use to allocate money? If we use $1000 worth of capital toward defined risk trades, how much should we use toward undefined risk trades?
Our study examined an at-the-money (ATM) $4 wide put spread versus an ATM Naked put. We compared initial delta, average profit, average loss, and buying power reduction with the goal to equate the performances and see the difference in the buying power.
Results found that three ATM spreads performed similary to 1 ATM naked put. So for every $1 in defined risk spreads should be treated as $5 in undefined risk naked puts.
A nice visual is then used to compare the differences. Taking on additional risks, such as selling the naked put, gets you higher average credit -- there is nothing surprising here -- an increase in risks should bring in an increase in potential profit.
For more information, please watch the segment.
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