First, a little about risk …
Every trader is intimately acquainted with risk. Trading both stocks and options has large potential for rewards, but also risks. In order to sustain a successful trading career, a trader must be willing to accept risk. The basic rule of thumb I was taught many years ago when I first started trading was “never trade with money you can't afford to lose.” There are no guarantees in trading that any position will yield a perfect reward. As a trader, you settle for the probabilities and potentials, and manage risk accordingly. Having said that, however, by predefining the risk you can afford to sustain, you can avoid making mistakes that jeopardize your entire trading account, and career.
Most traders are always trying to locate new strategies that offer healthy rewards with minimal risk. It is only with trading experience that you are able to easily assess the risk of a particular strategy and use it to your advantage. But, the basic rule of thumb remains the key to successful trading: Never take on the risk unless it's worth the return.
What are the two types of risks?
Basically, there are two types of risks – the known and the unkown. Each time you place a trade, you are putting the risk of that trade on the line. This is a known risk, because it involves a specific amount of money. The unknown risk that is lurking in the market can take on many forms. Everything from economic or political news, earnings, and natural disasters can have some effect on the market, creating this unknown risk.
Risk is not viewed the same by every trader…
One trader's perspective of risk may be viewed as irrational thinking by another. Risk is relative, but to the person who perceives it in a given moment, it is absolute and beyond question in his/her mind.
Understanding and accepting risk is the most important aspect of trading
There isn't any element of trading that is more important than having a true understanding of risk; how to accept it and how to manage it. Accepting risk means that you are able to accept the outcome of your trades without emotional despair or fear. It doesn't do any good to take on the risk of entering a trade if you fear the consequences; doing so means that you have not taken on the full understanding of risk.
The more successful traders not only take on the risk without any trepidation or fear, but experience has taught them to actually embrace that risk.
“When you genuinely accept the risks, you will be at peace with any outcome”. Mark Douglas
Having a complete understanding and the willingness to accept risk does not happen overnight; it evolves over time as you fine-tune your trading skills. It all starts as you develop your trading plan and identifying those strategies and associated risk level that work in conjunction with your account size, and trading style. The full understanding and acceptance of risk does not come immediately to a new trader; it is developed over time with experience back testing, paper trading, and trading live starting with small positions. As you learn to identify the risk associated with each and every trade, you will be more prepared to accept the inherent risk that goes along with trading, and eventually embrace that risk.
Now, let's talk about Risk/Reward Ratio and what it means in trading …
Risk/ratio is widely used by traders and financial professionals all over the world when analyzing a trade or investment. Basically, risk/reward measures the amount of reward expected for every dollar at risk. The risk/reward with complex options strategies can be useful to analyze positions to determine the relationship between the risk and reward.
Here is a very simple example of how risk/reward is calculated …
Let's say a friend asked you to lend him $25. In return for your agreeing to the loan, your friend agrees to pay you back $50 in two months. The reward (payback amount of $50), divided by your risk (amount of the loan of $25) equals the risk/reward ratio. In this scenario, you would have a 2:1 risk/reward ratio. You are risking $25 for a potential reward of $50.
Why is it important for options traders to calculate the risk/reward ratio?
Calculating the risk/reward ratio before entering a new position is an exercise most professional options traders perform on a regular basis. This habit can help you make a better decision in your trading. Sometimes, it may be surprising to see that the risk/reward ratio of some strategies that you feel are a “win/win” strategy are actually quite unfavorable when the math is worked out. Calculating the risk/reward ratio before entering a position can help avoid potentially unprofitable trades that are not immediately obvious. Many traders can also make it their own personal policy to only trade positions where a certain risk/reward is met. Some traders have as high a risk/reward ratio of 4:1 as their “threshold”, although a ratio of 2:1 is commonly used by retail traders as this ratio “theoretically” gives the trader the potential to double their money.
Let's look at some examples of a few options trades and the risk/reward ratio associated with each of them.
- Bullish Call Spread on XYZ Company
XYZ is currently trading at $12, and you have a bullish bias. You purchase a call debit spread, +10 strike/-$15 strike at a cost of $1.50. The maximum profit of the spread is $3.50 ($5, which is the width of the spread, minus the cost of $1.50). If XYZ closes at $15 above expiration, the full profit can be realized of $350 (less commissions).
Risk/reward ratio: $3.50 divided by $1.50 = 2.3, or a risk/reward ratio of 2.3:1.
- Iron Condor on ABC Company
You enter a 10-point wide Iron Condor on ABC Company and receive a credit of $1.25. The maximum potential profit of the trade is $1.25 (credit received), as long as ABC Company remains within the two short strikes. Your total risk is $875 ($1,000 for the 10-point wide wings, less your credit of $1.25).
Risk/reward ratio: $1.25 divided by $875 = .14, or a risk/reward ratio of .14:1.
In this second example, this type of risk/reward ratio is considered by many traders to be unacceptable; where you are risking $875 to potentially only make $1.25.
Summing it up …
Many options trades look and sound good at first glance. Sometimes, inexperienced traders may fall into the trap of not achieving their anticipated returns after entering a position even though the underlying is performing as they expected. The reason for this may be that they did not understand the true risk/reward at trade entry. Traders who have a full understanding of their risk, and the risk/reward of every trade before entering it can make a more informed, intelligent decision on which strategy to implement in order to maximize their profit potential.
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I hope this article serves as a refresher on risk and risk/reward. If you have would like to add anything you have personally found helpful in your trading regarding risk, feel free to comment below.