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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 a stock will move in the desired direction, and other psychological factors.

A trader with a nominal tolerance for risk and a strong conviction that a stock will rise may opt to buy the stock. 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 a stock will rise can choose from many types of trades to try to profit from a rise in the stock price. Consider three different trades, a stock purchase, a covered call, and a call purchase. All three trades profit if the stock moves up.
 Probability of a stock's future price Buying An At the Money Call Selling an ATM Covered Call

The chart on the left shows the probability of a stock'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 and puts are priced such that the probability of the stock price rising enough to cover the cost of the call is approximately 25%, therefore the probability of profit when buying a call is ~25%.

When selling the at the money call, the probability of profit equals the probability of the price rising (50%) plus the probability that the stock 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%.

Unlike the call purchase, the stock 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 stock 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 stock price moves against you.

When purchasing stock, 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.

The Trade Finder categorizes the risk tolerance based on the expected loss of a trade relative to the cost of the stock. The Trade Finder lets you match your risk tolerance with expectations of stock movement to pick an appropriate trade.

To use the Trade Finder, enter the stock symbol in the text box provided, select the Risk Tolerance and Account Type, then click Find Trades. A summary of selected trades will be displayed.

Data Provided by HistoricalOptionData.com
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