One of the most paramount central notions in stock and options trading is that of assessing potential risk and reward of any particular trade thesis. This is well known across the trading spectrum and of particular interest to intraday traders, who sometimes bypass this crucial step in planning. But what does it mean, and how can we accurately assess expected return and risk of any given trade? And how can we do this if we are trading options? This is a lot of questions, so what’s a trader to do? Luckily, you are in the right place. Let’s look at risk/reward analysis and determine what is generally considered appropriate.
Risk/Reward is a way traders look at how much they are willing to lose in an attempt to make a certain amount. It is often denoted as “risk reward,” “risk/reward,” “R/R,” or it is expressed as a ratio (1:3, for example). Essentially, a risk/reward ratio of 1:3 indicates that a trader is willing to risk one unit in order to make three units. Stated alternatively, the trader is targeting a possible 300% return. Any trade thesis needs to account for exit targets in both wins and losses before the trade is open. In other words, you need to know exactly when you plan to take profits or to cut the trade for a loss before you place the trade. Successful trading is data-dependent, and not planning in the chart when and where you will take profit and stop out is not a best practice, to say the least.
It appears that a largely respected risk/reward of 1:3 is considered broadly acceptable in the trading world. And, of course, many people are happy taking far less green than that. Scalping, for instance, thrives off of ten or fifteen percent gains harvested quickly on small time frames. Scalpers often pay little attention to R/R in the way it is discussed here. However, a trader should plan out and be aware of the risk/reward with which they are comfortable for the trade at hand. Many factors, of course, exert influence on each trade and it is very common for the same trader to utilize different risk/reward ratios for different types of trades they enter.
HOW RISK REWARD WORKS
Risk/reward analysis can help traders understand the real risk of any trade they put on. a r/r of 1:3 is common, but there are many options. Some may risk 1:5 or even 1:7. In this latter ratio, for every unit they are willing to lose, they are hoping to make seven. Arguably, the risk is the most important part of this ratio. It is imperative that traders know on the chart where and when they will stop out. Maybe it will be a support / resistance line, or a line of static or dynamic resistance. Regardless, a clear exit area if they trade goes against you is needed as part of your trading thesis. Many traders believe successful trading comes down to exit discipline and a good entry is one that provides an opportunity for a quick stop out if necessary.
The risk can be managed with stop losses, and this is definitely the recommended approach. Set your risk to an appropriate area, and respect the stops. The temptation to move stops in a losing trade is always significant, and it is to be resisted.
THE CHART IS KEY
Many new traders see risk/reward as too subjective. What does it really mean to say “I will risk one dollar to make three dollars,” and why in the world would it ever matter to anything outside of the individual trader’s mind? The truth is that without the proper grounding, risk/reward can be an exercise in meaningless subjectivity. Who cares if you are willing to undertake a 5:1 risk/reward ratio if there is no chance you can see 500% gains on the trade you just entered. Alas, the answer is simple:
The chart is the thing.
As with any trade thesis, you must have competent charting skills with solid support and resistance charted out before you begin your R/R analysis. You simply cannot pull a 3:1 R/R out of the air if the chart is not conducive to that undertaking. Trading is data dependent, and risk/reward analysis must be based on likely and real-world data. If risk/reward seems, or has seemed in the past, to you a bit too subjective then you might have likely not had as strong of a grasp on charting as is required.
Charting support and resistance can be a subjective affair, of course. However, if you plot out levels on various timeframes that are relevant to your trade plan, and if you know the ticker which you are trading, charting support and resistance isn’t that difficult. And whether it is S/R or other levels, your risk must be defined. Additionally, reward must be defined relative to the chart as well.
For instance, if you place your stop just above VWAP as your planned loss, the question is then where is the reward? Don’t choose a 1:3 or any x:y ratio randomly. Determine on the chart where the next level likely is.
R/R AN EXAMPLE
Imagine you are entering a long trade just above VWAP, and there is a huge resistance area just above. This exit target might provide a 1:1 or slightly higher R/R ratio. In many traders’ opinions, this wouldn’t be the best entry. Maybe it would behoove you to wait and see what happens at the resistance just above the current price action. If it rejects and heads down through VWAP, perhaps that could be an entry on a put play. Nonetheless, having basic support and resistance knowledge of any chart you are trading is essential to R/R analysis.
Conversely, if the aforementioned long biased trade is entered just above VWAP and there isn’t an obvious resistance for some distance (check all relevant chart time frames), you might have a logically expected 1:3 or more risk/reward. This is an example of how the chart must be utilized to help determine the ratio to be targeted.
And, it should be noted, that determining stop loss and the probability of success is difficult for all new traders and many novice ones. If a stock is currently trading at $75 a share, a trader may buy ten shares and place a stop loss order at 65$. If the trade goes against them, that is a loss of $100 (a ten dollar loss per share times ten total shares). A 1:3 R/R ratio would imply that the trader expects the stock to rise to $95 a share. This is a drastic increase, so this particular R/R ratio must be informed by the chart. The price action could very well be consolidating or even approaching a huge resistance area. If this is the case, the price seeing that big of an increase in a short time frame is unlikely. Probabilities are the name of the game.
Also, the trader might choose to move their stop up to $70. This limits their total loss, but it also increases the probability that their stop loss will be hit. Keeping stops too tight carries a real chance of those stops being hit while the inverse…keeping stops too wide…can lead to higher than acceptable losses. It takes time and experience for traders to find the “Goldilocks zone” when it comes to placing stop losses.
Therefore, proper stop loss choice is related to risk/reward analysis. And all of it depends on the levels that exist in the chart. It takes time to get proficient at risk/reward, but it is a crucial skill that must be mastered for a trader to be consistently profitable.
HOW TO DETERMINE RISK REWARD WITH OPTIONS
All this is good and well, but what about risk/reward for options traders? If you are new to options, be aware it takes a lot of experience and screen time to get comfortable with the unique properties of options that exert influence on price. You will have to spend some serious time learning about implied volatility, the greeks, and a lot more.
However, when it comes to determining risk/reward in options trading, all the previous discussions regarding charting, support and resistance, static and dynamic resistance, volume, and price action apply. And there is one additional element about which knowledge is required. It is imperative to contract selection, and it is the infamous greek, Delta.
DELTA SELECTION IN CONTRACTS
Delta is one of the easier greeks to understand in options trading. Delta expresses how much the option contract price will move relative to the underlying ticker’s price. It is expressed in decimal from .1 to .9, generally, and this info is clearly present on all option chains, regardless of broker.
The delta rating denotes how much the option contract price will move per a one dollar move in the underlying. A .5 delta will move 50 cents for every dollar the underlying moves. A .8 delta will move more violently and quickly at 80 cents per every dollar the underlying moves. This works to the upside and downside as well. A delta of .2 will only move twenty cents for every dollar the underlying moves, regardless of direction. And these options figures represent one hundred shares, so be aware to move the decimal points two places to the right. For instance, if an options contract with a .5 delta costs 250$, you can predict your gains based on a hypothetical move in the underlying. If the underlying was 300$ a share when the .5 delta contract was bought for the premium of $250, and the underlying increases one dollar to $301 per share…then the option contract would gain .50 cents (per share it represents) and the contract would then be worth $300.
It is this leverage that attracts traders to options. And, of course, it cuts both ways. It is to be respected. How can traders use delta in contract selection for risk reward analysis?
Understanding what delta represents and how it works, it is possible to estimate losses and gains on options contracts based on certain underlying price action. If you are buying an option on ticker XYZ, remember to do your charting on the underlying ticker’s chart. Some brokers allow you to see charts for options contracts themselves, and it is widely considered a bad idea to perform technical analysis on options contracts charts.
Again, as is always the case, solid charting skills will help you determine entries, exits, stop-losses, take profits, and risk/reward analysis.
Once levels are charted out, it is possible to make good entries and plan out your stop loss and take profit level. As for options contracts, you can apply the delta to the planned stop loss and calculate how much you will lose per contract. Additionally, the same simple calculation can be performed for your planned take profit area. For a quick, round-number example, if you buy a contract with a .75 delta for a $300 premium when the underlying is at $100, you can calculate the following very easily.
If a planned stop-loss area is when the underlying is at $98, your loss can be calculated as .75 cents per dollar lost on the underlying stock price. Your option contracts would be worth $150, or a 50% loss. And conversely, if the stock rose to $102 per share, your fifty percent contract gain would result in options contracts worth $450 each.
This sounds easy enough; however, be aware that a .75 delta option moves violently and quickly. And if anyone, anywhere, could actively predict underlying price action with certainty all the time, they would be worth trillions and the market wouldn’t work anymore.
And that leaves us with the final point: proper risk/reward analysis is akin to proper capital preservation. It must be data-driven, realistic, logical, and stops and take profit levels must be respected.
Greed can kill as much as not respecting stops.
There is a lot to it, but you can learn it if you go slowly and proceed with logic and caution. Don’t trade alone; thanks for visiting the Blog at BlackBoxStocks.