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Is It Really an Unlimited Loss?

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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

This segment puts reality to the concept of unlimited losses for those who short strangles, which should help small sized accounts and beginning traders be more comfortable.

Theoretically, a short call position has an unlimited loss potential because there is no absolute limit to how high a stock can move. A short put position also has a very high theoretical loss since the stock can go to zero.

A table was displayed of XOP (Oil and Gas ETF) including the price, implied volatility, implied volatility rank, a short strangle position that was established, credit received and days to expiration (DTE). There was another slide which displayed the formula for how to calculate the expected move. Based on the formula, the market is expecting the price to fall within $4.96 of the current price (either above or below).

A table outlined a trade of selling the XOP $37/$45 strangle for $0.86. The price of XOP was shown along with the calculated move, lower/upper range, probability of the move and the P/L if outside the range for 1, 2 and 3 standard deviation moves in XOP. This puts things into perspective. Theoretically, there is the potential for an “unlimited loss” (since the stock can go to infinity), but the reality is XOP is unlikely to go up forever based upon standard deviations.

A study was conducted from June 2010 to present examining the expected moves 45 days away. The study was on four popular stocks, AAPL, EEM, GS and USO. The study included how many times these stocks and ETFs landed outside their 1,2 and 3 standard deviation ranges. The results showed the percentage of moves outside the calculated expected range (1 standard deviation) plus the percentage of moves outside the 2 and 3 standard deviation moves for each stock.

Takeaways:

Theoretically, naked short strangles and straddles have unlimited loss, but in actuality that is rarely the case

Underlying stocks and ETFs often stay within their expected standard deviation ranges more frequently than the market anticipates.

Watch this segment of "tasty BITES" with Tom Sosnoff and Tony Battista for the results of the study and to learn the percentages of a 1, 2 and 3 standard deviation moves. This should increase your confidence when considering placing trades with “unlimited risk”.

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