How to Create the Proper Risk/Reward Profile for Your Trades

How to Create the Proper Risk/Reward Profile for Your Trades

Posted On March 4, 2022 12:54 pm

Market’s are back to last week’s lows.  As mentioned, “Oversold Doesn’t Mean Buy” Options360 has shifted to a more bearish stance, establishing an SPDR S&P 500 (SPY) put option position that’s playing out nicely.  I can’t get into the details yet because it’s still open and we’re making adjustments to lock in gains,  and I don’t want to jinx it. 

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Instead, let’s get back to viewing and managing the risk and reward of an individual trade and portfolio. 

In yesterday’s article,  we discussed how we calculate returns on a risk-adjusted basis in percentage and dollar terms. This is applied within each position’s context and the overall portfolio. Now, let’s take a look at how setting up the proper risk/reward profile for each position will boost overall profitability in your options trading.

A big secret that many rich traders know, but new traders do not is that even the winning percentage of top traders is only about 50%-60%. Having big winning trades and small losing trades is their edge

Big losses will kill your account quickly and small wins will do little to pay for those losses. Our trades have to be asymmetric, with the downside carefully planned and managedHowever, our upside is open-ended. This is a crucial element 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 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 with the amount of money risked to capture profit. This ratio is calculated mathematically, by dividing the trader’s expected profit when the position is closed (the reward) by the amount the trader could lose if the price moves in the unprofitable direction/the trader is stopped out for a loss.

One of the biggest mistakes novice options traders make 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, because you are much more likely to rip them with a 100% loss than you are to hit the jackpot.  And remember, these options come with an expiration date, meaning you need an outsized price move that must occur within the right time frame.

In setting up a trade, I take three basic steps.

First, 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 and helps you set a realistic price (profit target). It also limits risk; if support is broken, the position gets closed for a small loss. Ideally, the price target should be at least 2x the price magnitude as the stop loss level.

Second, choose a strategy that’ll 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.

Last, allow sufficient time for your thesis to play out. If this is a turnaround story, you’ll want options that have an expiration that is 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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About author

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.