The traditional model in finance for risk and return is very simple and straightforward: more risk, more return. In other words, if we take on increased risk in an investment, then that one singular trade should provide us with an increased return. The classic way to measure a stock’s risk would be by examining its beta, or its risk relative to the overall market. Conventionally, stocks have been divided into “growth” stocks and “value” stocks. Growth stocks are typically your higher beta stocks (more risky than the market), as these companies aim to grow, expand, and innovate. Value stocks are typically your lower beta stocks (less risky than the market), with these names focusing on the same products and services that have brought them success at the expense of dramatic growth and innovation.
When we sell premium, the very nature of being short options brings about increased risk (as their losses are theoretically unlimited.) However, the return associated with this greater risk should not be viewed as one, singular increased return. Instead, assuming more risk as an option seller begets more opportunities to generate returns, rather than a greater return from a single trade. This is how our perspective of risk and return differs from that of a traditional, passive investor.
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