The options business is all about risk assessment. Yet, many options traders don’t understand portfolio risk when utilizing options strategies. And the more complex the options strategy, the more complicated the risk assessment.

One way to approach risk assessment is a concept known as “equivalent share position.” ESP allows you to assess the total number of underlying shares associated with an options strategy and, ultimately, the leverage being employed within the portfolio.

To add some meat to this skeleton, consider this hypothetical example: a trader takes a position in two stocks — ABC trading at $25 a share and XYZ trading at $50 a share. The options on both stocks are trading at implied volatilities of 40%.

The first trade involves the purchase of 20 XYZ Oct 50 calls at $5 a share (total investment = $10,000). The second trade is a covered call write, in which the trader buys 1,000 shares of ABC and writes 10 Oct 27.50 calls at $1.50 a share. The total investment in ABC is $23,500 ([1,000 shares x $25] – $1,500 in options premiums). Thus, the total capital committed, overall, is $33,500. (The remaining $16,500 of the portfolio is in cash.)

At this stage, we have a long call position on XYZ and a covered call write on ABC. The objective is to determine how much risk and leverage is being assumed by the portfolio.

The 20 XYZ calls grants the trader the right to buy 2,000 shares of the underlying stock, which you might argue is the ESP of the strategy. But that is not exactly correct. In reality, if XYZ were to decline to $0 a share, the calls would expire worthless. The most the trader would lose is $10,000 (2,000 shares x $5 per share = $10,000), which is the total cost of the calls.

If we are to examine the risk profile of an options strategy, limited risk plays a role, as does time to expiration and the relationship between the strike price and the price of the underlying security. ESP calculates this in real time.

ESP takes into account the option’s delta, which is a derivative of the option pricing formula that tells us how much an option is expected to rise or fall, given a $1 move up or down in the underlying stock’s price.

Any Internet-based options pricing calculator provides the delta, along with other derivatives. For example, you could use the options calculator at the Montreal Exchange’s website (www.m-x.ca/outils/calculateur/calc_legal_en.html).

In the XYZ example, the XYZ Oct 50 calls have a delta of 0.55. This suggests that over short periods, the XYZ Oct 50 calls should rise or fall by approximately 55¢ for every $1 change in the price of XYZ.

The ESP is simply the underlying number of shares (2,000 shares, in this case) multiplied by the option’s delta. The options trader has a position that is equivalent, in terms of risk, to holding 1,100 shares of XYZ (20 contracts x 100 shares per contract x 0.55 = 1,100 shares) at $50 a share.

The same methodology applies to the ABC holding. In this case, the trader bought 1,000 shares of ABC. When you buy stock, you are buying a delta of 1.0, which represents an ESP of 1,000.

The delta on the ABC Oct 27.50 call is 0.40, but unlike the XYZ example, in which the trader was long the calls — creating a positive delta — the short ABC calls correspond to a delta of negative 0.40. That represents an ESP of minus 400 shares (10 contracts x 100 shares per contract x 0.40 = 400 shares). Effectively, then, the risk in the ABC covered call write is equivalent to being long 600 shares of ABC at $25 a share.

At this stage, our hypothetical trader’s portfolio is assuming the risk associated with 1,600 shares of two stocks trading at different prices. To determine portfolio risk, simply multiply the 1,100 shares by $50 each, plus 600 shares multiplied by $25 each, which equals $70,000.

Essentially, the investor is holding a $50,000 portfolio that, in terms of risk, will act like a portfolio worth $70,000. For the record, this portfolio is leveraged to the tune of 40%.

The point is: investors would do well to understand position risk before committing to a trade.

ESP is simply a tool that can help break down the risk and leverage associated with complex options positions. Understanding how to use ESP can help traders fine-tune the risks associated with any options position and, by extension, provide a clearer perspective regarding the leverage being employed at a point in time. IE