Understanding Risk & Reward Ratio For Option Traders

In this article, the options trader will learn :

  • Why a favorable risk and reward ratio is essential to earning a living as an options trader
  • That cutting losses when a trade goes wrong is essential to preserving capital
  • Why increasing the percentage 0f winning trades will help to grow the portfolio or account balance

When a gambler goes to a casino and bets against the casino, the odds are stacked against him. However, in a game called Black Jack, by card counting and other means, the gambler is able to tilt the odds in his favor, as proven by Ed Thorp, a card counting expert who famously proclaimed through his book to have beaten the dealer at his own game. At the same time, risk-reward probabilities are also factored into the game. Similarly, for an options trader, the trader has to increase his odds and at the same time, understand how to make the risk and reward ratio of a particular trade work for him. An options trader should not be concerned with a 20% return on investment unless he can make many of such trades pan out with high probability. But since the game is one of leverage, an options trader should trade more often when the odds of a huge potential profit is high. He is looking for a 100% or more with regards to the return on investment.

Let us look at a few examples that may bring to light these issues.

If an options trader has $100,000. And he keeps to the 5% money management rule where he places a maximum of 5% of his capital into each trade. [Read about : Intelligent Money Management For Options Traders] For all the hypothetical scenarios below, the trader invests an amount of $5000 into each trade.

If the trader is a novice trader, he may have a winning percentage of 1 out of 5 trades. That means that for every 5 trades he makes, he loses on 4 trades and only makes a profit on 1 trade. Do note that this is an oversimplified example to facilitate learning here.

Trade 1 Trade 2 Trade 3 Trade 4 Trade 5
Percentage loss(-) or profit(+) -100% -100% -100% -100% +20%
Absolute amount earned(+) or lost(-) -$5000 -$5000 -$5000 -$5000 +$1000

Note: The options traders risks 5% of $100,000 which is $5000 into each and every trade.

Beginning balance of portfolio Ending balance of portfolio
$100,000 $100,000 – $5000 x 4 + $1000 = $81,000

The options trader’s account balance or portfolio will be left with just $81,000.

However, if the options trader has a strict risk and reward criteria of a potential 200% profit for every trade he makes, this is how his trades will look like with the assumption that he loses on the first 4 trades completely.

Trade 1 Trade 2 Trade 3 Trade 4 Trade 5
Percentage loss(-) or profit(+) -100% -100% -100% -100% +200%
Absolute amount earned(+) or lost(-) -$5000 -$5000 -$5000 -$5000 +$10,000

His portfolio will now look like this.

Beginning balance of portfolio Ending balance of portfolio
$100,000 $100,000 – $5000 x 4 + $10,000 = $90,000

Now, as you can see, his ending portfolio balance is $90,000. His losses as a whole are not as severe than the previous scenario.

Now, let’s examine the scenario where he becomes more proficient as an options trader and still demands a potential 200% profit before he makes a trade. His winning percentage is now 40%, which is essentially 2 out of 5 trades.

This is how his trades will look like.

Trade 1 Trade 2 Trade 3 Trade 4 Trade 5
Percentage loss(-) or profit(+) -100% -100% -100% +200% +200%
Absolute amount earned(+) or lost(-) -$5000 -$5000 -$5000 +$10,000 +$10,000
Beginning balance of portfolio Ending balance of portfolio
$100,000 $100,000 – $5000 x 4 + $10,000 x 2 = $100,000

As you can see from above, his portfolio will have no losses as the beginning balance is equal to the ending balance.

To improve the return on the overall portfolio, the trader may use stop losses to cut losses when his bets and predictions are wrong. For example, the trader may choose to cut losses when there is a 20% loss on a trade. When that happens, his trades will look like this:

Trade 1 Trade 2 Trade 3 Trade 4 Trade 5
Percentage loss(-) or profit(+) -20% -20% -20% +200% +200%
Absolute amount earned(+) or lost(-) -$4000 -$4000 -$4000 +$10,000 +$10,000

The options trader has lost a total of $12,000 on 3 trades but has made a profit of $20,000 on 2 other trades. When that happens, his ending portfolio balance or account balance will look like this:

Beginning balance of portfolio Ending balance of portfolio
$100,000 $100,000 – $4000 x 3 + $10,000 x 2 = $108,000

Compare the beginning balance to the ending balance of the portfolio. His portfolio balance has grown by $8000.

For the last scenario, building on the previous one, let us assume that the trader becomes so proficient that he makes 3 winning trades out of 5 winning trades. The trades will look like this.

Trade 1 Trade 2 Trade 3 Trade 4 Trade 5
Percentage loss(-) or profit(+) -20% -20% +200% +200% +200%
Absolute amount earned(+) or lost(-) -$4000 -$4000 +$10000 +$10,000 +$10,000

Now, his account or portfolio balance will look like this:

Beginning balance of portfolio Ending balance of portfolio
$100,000 $100,000 – $4000 x 2 + $10,000 x 3 = $122,000

Now, his portfolio has grown by $22,000 from the beginning balance.

Do take note that all the scenarios here are built upon the immediate and previous scenario.

Summary

The options trader must demand a risk and reward ratio that is favorable to him. The whole idea is to earn a high return on investment for each winning trade and to reduce the loss on investment in each losing trade. As the trader becomes more proficient in finding winning trades, his portfolio will grow as well. If there aren’t trades that meet his risk and reward criteria, the experienced trader will refrain from making trades. In general, money management discipline, favorable risk/reward ratios and a high percentage of winning trades will make a trader a successful one.

Next, Read:

Read: How Option Traders Can Use The Kelly Formula To Increase The Rate Of Return Of A Portfolio

Read: How Option Traders Can Increase The Winning Percentage Or The Probability Of A Positive Return On Investment