How to Boost Profitability Using a Smart Risk-Reward Profile
By: Steve Smith
Today, I want to discuss how setting up the proper risk/reward profile for each individual position will boost your overall options trading profitability. A big secret that many rich traders know, but new traders don’t is that the winning percentage of the top traders is only about 50% to 60%. It’s those big winning trades and small losing trades that give them an edge.
Big losses will kill your account quickly and small wins will do little to pay for those losses. Our trades must be asymmetric, where our downside’s carefully planned and managed, but our upside’s open-ended. This is crucial for options trading success and has to be understood and planned for. Consider the following sets of risk/rewards with win rates.
With a 1:1 risk/reward ratio and a 50% win rate, a trader breaks even.
With a 2:1 risk/reward ratio and about a 35% win rate, a trader breaks even.
With a 3:1 risk/reward ratio and about a 25% win rate, a trader breaks even.
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The risk/reward ratio is used by more experienced traders to compare the expected trade profits to the amount of money risked to capture the profit. This ratio’s calculated by dividing the trader’s expected profit amount when the position’s closed (the reward) by the trader’s loss amount if the price moves in the unprofitable direction and he or she’s stopped out for a loss.
One of the biggest novice option trader mistakes is buying way out-of-the-money calls. These options, with their typically low dollar cost, seemingly set up a great risk/reward profile. You can only lose what you pay for the option, and profits are theoretically limitless. I refer to these as “lottery tickets,” as they’re much more likely to rip them with a 100% less than you are to hit the jackpot. And remember, these options come with an expiration date, meaning you need an outsized price move to occur within the right time frame.
In addition to these OTM options’ low success probability, they also may not be as cheap as they seem. In options trading, it’s not just the dollar amount that determines whether it’s relatively cheap or expensive, it’s the implied volatility. Often the implied volatility on these OTM is very high, causing inflated premiums. This is especially true ahead of pending news such as earnings or takeover chatter when the lottery aspect of these come fully into play.
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In setting up a trade, you need to take three basic steps:
- Use the chart to find an attractive entry-level and define your trade parameters. This means buying near support and selling at resistance levels. This provides an attractive initial price while also helping you set a realistic price (profit target). It also limits risk. If support’s broken, the position gets closed for a small loss. Ideally, the price target should be at least twice the price magnitude as the stop loss level.
- Choose a strategy that will deliver at least a 2:1 risk/reward if the price target is achieved. If the target is small and the stop is tight, one can simply buy an at-the-money call. If the parameters are wider, then using a spread might make more sense.
- Allow sufficient time for your thesis to play out. If this is a turnaround story, you’ll want options that have an expiration that’s at least 8-12 months away. If you’re just looking for a quick technical bounce or an earnings announcement, using shorter-term options — anywhere from two weeks to three months — will provide better returns.
The bottom line: Managing risk is more important than trying to always be right.
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Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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