When people hear of undefined vs defined risk option strategies most people just think of limited vs unlimited risk and nothing more. In this comparison, most people think a limited risk trade is an obvious choice. But actually, there are many more factors that should impact that decision. Sadly, most people don’t know these factors. In this article, I will break down all the differences between undefined and defined risk option strategies. To visualize the differences in the best possible way, I will present them with an example. To keep things simple, I chose two simple option strategies to represent undefined risk and defined risk trades. The strategies are a bear call credit spread (defined risk) and a naked (short) call (undefined risk). The only difference between these two strategies is that the credit spread has a long call a few strikes above the short call. This added long call acts as protection and defines/caps the risk. Just because I use these two strategies to explain the differences, does not mean that the differences only apply to these strategies. The differences can also be seen in most other strategies. become very large. tastyworks undefined risk Undefined Risk of a Short Call Let’s look at the same scenario with one difference. This time, you opened a call credit spread. You sold the $280 call and bought another call at the $283 strike. Once again, SPY’s price rises sharply. But as soon as the stock price passes the $283 mark, your maximum achievable loss is reached (on expiration). From that point on, it really does not matter how much further the price would rise as your loss wouldn’t increase. This is the case because the profit achieved from the long call offsets parts of the loss achieved from the short call. So your loss at expiration if SPY would close at $350 wouldn’t be more than if SPY would close at $284. tastyworks defined risk Defined Risk of a Call Credit Spread This is the most well known and most obvious difference. But there are more differences that are important as well. Premium – Max Profit The next, still very important difference comes from the premium taken in. The premium/credit received when opening trades will almost always be larger for undefined risk strategies. This is because you have to pay for protection on defined risk strategies. This reduces the overall credit taken in. Let’s take the example from before again. SPY is trading at $275 and you sell the $280 call for a credit of $2.63 or $263. These $263 are also the maximum achievable profit for that trade. tastyworks undefined profit Max Profit of a Short Call Now let’s compare that to the max profit of a call credit spread on SPY. You sell the exact same option for the same price ($283). Furthermore, you buy the $107 call for a debit of $1.63 or $163. In other words, you pay $163 for the added protection and therefore, your max profit decreases to $100 ($263-$163). tastyworks defined profit Max Profit of a Call Credit Spread Together with the risk, the reward also decreases for defined risk trades. This can have more impact than you think. The next difference is a direct consequence of this. Break-Even-Points – Probability of Profit The decreased premium has an impact on the break-even-points and probability of profit (POP). More premium leaves more room for the price to move in before having a loss. In other words, premium creates a buffer room and moves the break-even-points further out. That is also why the break-even-point on a naked call isn’t right at the call’s strike price but somewhat further out. The greater this premium is, the further out this break-even-point moves out. This impacts the probability of profit. If the price of the underlying has to move further to create a loss in your position, the probability of profit increases as a big move is less likely than a small move. credit spread Probability of profit POP + BEP of a Credit Spread Therefore the naked call from before has a higher probability of profit than the call credit spread. As you can see on the images, the credit spread has a probability of profit of 63% and the break-even-point is right at $281. The short call, on the other hand, has a probability of profit of 67% and the break-even-point is around $282.5. Short call probability of profit POP + BEP of a Short Call Buying Power – Return On Capital (ROC) A further major difference between these strategies is the impact on the buying power. Defined risk strategies have a limited risk and therefore, your broker only reduces your buying power by the amount of the risk. The buying power reduction for undefined risk strategies, however, is much greater as there is no real max loss. Due to this, your return on capital (ROC) is much lower for undefined risk trades. You have to allocate more money to make a little more. Once again, I will explain this further with the example from before. The max loss of the call credit spread on SPY is $200 ($3 x 100 – $