In an earlier post today, I presented the list of Option Strategies with the highest "Mathematical Probability" of success. I hope each of you had a chance to read it. Now I want to discuss how to use Risk and Reward when determining an option play or strategy.

First let's define risk. Merriam Webster says, "the chance that an investment (as a stock or commodity) will lose value." Next, let's define reward. Merriam Webster says, "something that is given in return for good or evil done or received or that is offered or given for some service or attainment." Finally, let's define risk/reward ratio. I would go as far as saying..."A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction (i.e. the risk).

When deciding on a strategy to use, you must consider what risks are involved, and what the potential outcome could be (reward). Some may already be familiar with the risk-reward concept, which states that the higher the risk of a particular investment, the higher the possible return.

My earlier article captures the strategies with the highest probability of success, but with a higher probability of success comes a smaller reward potential. If there were a high probability trade with huge reward potential, every trader would be taking that same trade, and no one would want to be on the other side of that deal (lower probability & lower reward).

Most of you know a little about my background. I am the Unicorn of the bunch. I don't go for the "easy wins" because I don't make a lot of money doing it. I go for the long shots. While taking these chances may not result in many wins, I have never judged a successful trader by his batting average. I judge him by the amount of money he has in the bank. With a low probability strategy, you may not be right very often, but when you are right there is a great reward behind accomplishing this feat.

All traders are not created equal! You might be comfortable trading the high probability strategy with many small rewards, or prefer the low probability system with high reward. This is for you to decide, not me. However I highly recommend whichever strategy is chosen, be in control of what is at risk, because the improbable loss could be around the corner, and that changes everything.

We have talked thus far about strategies, but how about individual trades? I want to use a couple examples to help illustrate how to apply risk/reward to each trade. Assume I have an option I want to purchase for $4. The stock is trading at $60, and I am expecting a $6 move out of the stock. Let's assume when the stock makes this move, the option will be trading for roughly $10. My reward in this trade is $6. What risk am I willing to absorb to make this $6? Let's say I use a 50% stop, meaning once the price of the option hits $2, I exit the trade getting $2 back. In this example, my risk is $2. If I do the math...my reward of 6 divided by my risk of 2 equals a reward/risk ratio of 3:1.

Remember, our reward is only as reliable as our forecast. The more factors you have pointing to this potential move increase the probability of the move. You also control risk...so if you want to tighten a stop order, do it! Just make sure it is not so tight that you lower the probability of getting the profit (stopped out). I hope this was helpful for some. If you don't walk away from this with anything, at least know that you ought to be comparing your potential profit to what you are willing to risk. Aim for the higher R/R trades...3:1...4:1...5:1...etc. "But Jeff, where do I find these trades?" (That is what you are thinking, right?) This is why I trade pattern breakouts, where stocks can have huge target prices. If I set that up with a low probability trade, with a potential for huge gains...it increases the likelihood of making more money than I lose. Which is the lesson every trader needs to learn on their own....how to make more money than you lose.

One last example...If you trade 4:1's and are only right 30% of the time... You have three wins that equal $12 (4x3=12) and losses that equal $7 (7x1=7). You'll walk away up $5 in this scenario. Anyway, run a few numbers and be cognizant of this in your trading and strategy decisions.

Yours Truly,

Dude,
When did you learn how to wright so well? That kicked A$$!

Deltatrader

Great post Jeff. Can't wait to read your posts every day.

Elementary question (so please humor me) when one trades OTM and are looking at reward, what is the basis calculated on? Is it anticipated intrinsic value at the target price or the best educated guess of movement based on the delta etc.? It maybe just too late right now to soak it in, but a review is always appreciated.

Travis,

Since Jeff isn't answering and he learned everything he knows from me anyhow, I'll throw in a response to your question.

You might want to try using the black scholes calculator. You can account for time decay and implied volatility with it. This method isn't as theoretical as some folks think. It's good tool for figuring target prices.


Deltatrader

Travis,

DeltaTrader beat me to the punch. Black scholes is a great way to do this, and it will create a need for you do investigate volatility a little more in depth. I think every trader needs to do this a little more.

Thanks!

Okay, follow up to Deltatrader and Jeff's reply...

If I click on the T-val price on the IT website when looking at the greeks, I get a triangle with all of the current values plugged in. I see the effect of time decay and the quicker the price movement the greater the gains that are experienced. I see what happens if you hold the option until the end and the t-val of the option with all time priced out at that time. This makes sense.

Now, that is only based on the current conditions, correct? If I go the Blackscholes calc on the website, I get a bit lost. I was playing with it and did see the difference the volitility input can make in the price but I think I am getting lost in the forest because of the trees.....and to think I used to just worry about trend and strike price...hahahahaha.

Jeff, where is a good tutorial on using the BS calc on the website? Did my coach miss that with me on the basic options course????

Trying to learn but my brain hurts....

Thanks for your patience.

Travis,

Black Scholes is not basic options. If your coach didn't walk you through this, it was probably for your own good. I will go out on a limb here to claim myself as a black scholes master, in fact let's refer to it from now on as black scholes kohler. Jokes aside, this is why I made the company offfer an options pricing course. Get into one of these sessions asap to get a better understanding of how to use this tool and options pricing in general. Or I might just write a post on it eventually...

Jeff,

Your candor (and love for youself hahahah) cracks me up. I love this blog. This has been the most formally informal information I have received yet. I love the post you did about this and how to use the black scholes kohler. I will be starting up the advanced options soon as I am finishing the advanced tech rooms. Great content all around and I continue to learn something new daily. BTW, post sometime your learning curve and how you came to voraciously attack understanding options and who your mentor(s) was/were. Just a FYI thing for us. I know you mentioned options was something you fell in love with and new you wanted to learn and trade them. I am sure this was not something that was readily given to you as a broker. Just a thought. Thanks for the answer and post....

Hi Jeff,
I really enjoy many of your thoughtful posts on this blog, as well as sessions I’ve attended in Masters Talk and Trading Rooms. This area of risk/reward intrigues me a lot. What I'm trying to figure out is the probability aspect contrasted with various reward/risk scenarios. As you point out, there are many nuances to this. Personal style plays into choices as does accuracy in making a forecast based on technical analysis, etc.
So, the question I'm asking myself based on my own style and previous experiences (good and bad) is whether trades that only yield 5-10% return but on which I'm right 90-95% of the time aren't more profitable in the long term than something more aggressive (i.e. potentially more profitable) but have less chance of success on a consistent basis.

For example, as I look at many credit spread opportunities, I see some pretty conservative trades that can actually yield as much as 20% ROI (but often are more like 5-10%). While going for the higher percentages can be appealing, I’ve been burned too many times by my inability to correctly forecast the trend or by simply taking a riskier trade to chase the bigger money. So, one question I wanted to pose is if there is any way to assess the probability of the trade being successful based on factors such as support/resistance, strike price chosen, market trend, stock trend, etc? I hear people throw out probabilities in percentage form many times and that makes me wonder how scientific that number is. The second question is whether you’ve encountered traders who have achieved something approaching 90% successful trades using more conservative approaches.

Mark

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  • I'm Option Addict
  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
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