A Minor Misunderstanding

The other day I ran into my old friend, Joyce, who teaches at the Blue Ridge Community College in Hendersonville. Periodically, she joins my Séances where a group of us meet to discuss trading strategies and the stock market. Recently, she developed an interest in trading options on stocks.Joyce had an idea she wanted to present to our group. She was very excited because she felt it would be a great strategy to purchase options on a leveraged ETF. She figured that since the leveraged ETF, such as TNA, moves three times as fast as the underlying IWM, she would get extra returns by buying options on the more volatile TNA as compared with buying options on the stodgy IWM.  (IWM is the 1x, non-leveraged ETF for the Russell 2000 small-caps.) This should also work with the S&P 500 by buying options on SSO or BGU. SSO is leveraged 2x and BGU 3x, she suggested.On the face of it, this appeared to be attractive. I asked if she had compared their risk to reward profiles. She hadn't. Joyce asked me to do this with her option strategy.    I responded: "To a small degree, it's an art form; but basically easy with the right tools. We would employ the use of the option chains and an option calculator." These are readily available on-line for anyone wanting to trade options.  (You can check out the Hoadley Option Calculator and the Kainnito option calculator to name just two - Google them.)We agreed to examine the January Calls for IWM and TNA.  At that time, IWM was priced at $73.53 and TNA $60.18. IWM's $70 strike price was selling for $5.15 and TNA's $55 strike was at $10.50. Let us compare the two. Two contracts of the January IWM 70 would cost about the same as one contract of the January TNA 55. Next we looked at the option calculator. At expiration, a 10% gain in IWM would yield a $1,140 profit for the two IWM options, factoring in a $10 commission. The reward-to-risk ratio 1140/1040 = 1.096To properly compare TNA's gain to IWM's 10% gain, it is necessary to find the profit provided when TNA has risen 30%, because of the 3x leverage.  At expiration, a 30% gain in TNA would yield a $1,264 profit of the TNA options contract. The reward-to-risk ratio 1264/1060 = 1.192. The difference in the ratios is less than 10%.Joyce was a little disappointed. She felt the increased volatility would have made a much bigger difference in their relative profits. I suggested we compare their Open Interest which is part of the option chain table. The value on the IWM call was over 24,000 while TNA's value was under 1,600.  Joyce asked: "Why is that important?"Open Interest relates to the ease of trading options.  First, high open interest implies there are many buyers and sellers for the option. Second, it results in the Bid and Ask prices being close together. With IWM the difference is pennies; with TNA it's over $0.75.  That amount of difference could easily wipe out the theoretical difference in the two reward-to-risk ratios.  Therefore, my recommendation was to trade options on the underlying, IWM, rather than on the leveraged ETF, TNA. This concept applies to other leveraged ETFs, primarily because their open interest would be less than TNAs.  Based on that, Joyce thought she would take a closer look at IWM.