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,

Posted by Option Addict on 8/29/2006 at 2:18 PM | Permalink