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Why Well-Defined Risk/Reward Parameters Are Essential for Successful Traders

Why Well-Defined Risk/Reward Parameters Are Essential for Successful Traders

Posted On July 28, 2021 1:35 pm
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Yesterday I wrote about how size matters.  That is how to keep any single position to just 3%-5% of the overall portfolio.  Additionally, keeping 20% – 30% in cash is a form of risk management. 

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Unlike institutional investors, who should really have 90% – 95% of their money in the market — even if some are cash-equivalent bonds yielding next to nothing — we at Options360 have the luxury of being patient and waiting for good setups that offer an attractive risk/reward. Institutions are mostly price-insensitive, simply allocating the money they manage, which is why most funds are “closet index huggers” and basically match S&P 500 (SPY) returns year-over-year.  

On the other hand, Options360, or an individual investor/trader, can keep plenty of dry powder but also employ important risk management tools through the mentioned proper position sizing and setting loss-limiting defined trade parameters.  This can cut both ways. However, the first directive’s to protect your capital, and profits then follow. 

I’ll use three trade examples we made in Earnings360 yesterday.  We placed a bullish trade in Advanced Micro Devices (AMD) along with iron condors in Apple (AAPL) and McDonald’s (MCD). 

This morning, all were looking like winners with potential gains of 50% – 80% on these overnight trades. But, I also understood the need to define our risk. Hence, as I do with all earnings trades, I sent the following Alert prior to this morning’s opening. 

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  1. AMD is indicated up 2.5% around $93.50 after beating on the top and bottom line and boosting guidance.

Exit Plan:

-Enter order to close around $3.00

-For risk management, if shares drop below $90 will exit. I’ll send an Alert if that occurs

ACTION:

-Sell to close 2 contracts AMD August (8/06) 89 Calls

-Buy to close 2 contracts AMD July (7/30) 92 Calls

For Net Credit $3.00 (+/-0.10)

  1. AAPL is indicated down about 1% around $145.5 after beating on the top and bottom line but warning chip shortages will impact sales in coming months.

Exit plan:

-Order to close around $0.25

-For risk management, if shares hit $142 or $150 will close. I’ll send an Alert if this occurs.

ACTION:

-Sell to close 2 contracts AAPL July (7/30) 140 Puts

-Buy to close 2 contracts AAPL July (7/30) 142 Puts

-Buy to close 2 contracts AAPL July (7/30) 152.5 Calls

-Sell to close 2 contracts AAPL July (7/30) 155 Calls

For a Net Debit of $0.25 (+/-0.05)

  1. MCD is indicated down 2% around $244 despite smashing estimates powered by chicken sandwiches. I gotta try one of those.

Exit plan:

-Enter order to close around $0.20

-For risk management, if shares hit $240 or $250 will close. I’ll send an Alert if this occurs.

ACTION:

-Sell to close 2 contracts MCD July (7/30) 237.5 Puts

-Buy to close 2 contracts MCD July (7/30) 240 Puts

-Buy to close 2 contracts MCD July (7/30) 250 Calls

-Sell to close 2 contracts MCD July (7/30) 252.5 Calls

For a Net Debit $0.20 (+/-0.05)

Unfortunately, AMD and MCD quickly breached the stop-loss levels.  However, both still delivered a small profit.  I say unfortunately because an hour later both positions moved to the initial target entry points.  Did I leave some money on the table?  Yes.  Did I prevent taking a big hit? Yes. 

And, AAPL did hit our targeted exit of $0.25 — delivering a 45% return. 

My point is this:  Establishing well-defined risk/reward parameters is two-fold. It will prevent you from second-guessing yourself, and it’s also a key element to achieving consistent returns. 

While I used earnings trades, which play out in a day as examples, I apply these same principles to the longer-term Options360 trades. 

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About author

Steve Smith
Steve Smith

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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