a matter of strong conviction

Every trader is different. Traders have different investment objectives and different expectations regarding the returns on their trades. Experienced traders know that increasing the return on an investment involves increasing risk. Just how much risk a trader is willing to take depends on how much capital is available, how much a change in capital can effect one's lifestyle, the amount of conviction that an asset will move in the desired direction, and other psychological factors.

A trader with a nominal tolerance for risk and a strong conviction that the underlying asset will rise may opt to buy the asset . A more conservative trader may sell a covered call, and a more aggressive trader may buy a call.

A trader with a strong conviction that an asset price will rise can choose from many types of trades to try to profit from a rise in the underlying price.

Consider three different trades, an asset purchase (could be futures, a covered call, and a call purchase. All three trades profit if the underlying asset (stock index, currencies, commodities, etc) moves up.

The chart on the left shows the probability of an asset's price in the future. The center line represents the current price. The probability of the future price being greater than the current price is the area underneath the curve to the right of the center line which is .5, or 50%. The probability of a future price being far from the current price is small.

The at the money call is only profitable when the price rises above the current price plus the cost of the call. Calls are priced such that the probability of the asset price rising enough to cover the cost of the call is approximately 25%, therefore the probability of profit when buying a call is ~25%.

SELLERS HAVE AN ADVANTAGE

When selling the at the money call, the probability of profit equals the probability of the price rising (50%) plus the probability that the asset does not lose more than the amount that was collected when the call was sold, which is approximately ~25%. The probability of reaping some profit is ~75%.

• When purchasing an asset the probability of profiting, and the expectation of loss, are both 50%.
• The probability of profit when buying a call is lower (25%) than when buying an asset.
• The probability of profit when selling a covered call is higher (75%) than when buying an asset.

Unlike the call purchase, the asset and covered call purchases put a lot of capital at risk.

If the only criteria for measuring risk is the amount of capital exposed to loss, then purchasing the asset is the riskiest trade of the three.

The measurement of risk has to take into account the probability of the future price, and how much loss is expected to be incurred given that the asset price moves against you.

Dice is loaded against Buyers

When purchasing an asset, the probability of losing some of the capital invested is 50%. When purchasing a call, the probability of losing all of the capital invested is 50%. When risk is measured by the probability of loss, or expectation of loss, then buying the call is the riskiest trade.

In short, the buyer of call or put options can't afford to be casual or reckless.