Different Risk/Reward Scenarios

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Posted on Wednesday, April 26, 2017 at 3:08 PM

If you have heard me before, you have often heard me say that options have so many moving parts. There are so many more areas to learn and understand than there is for say just trading stocks. As an option trader, you have so many different strategies and risk/reward scenarios to think about before initializing a trade. Many of my students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread as one example. Let's take a look at a scenario below and some things for an option trader to think about.

Risk and Reward

A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread depending on how it is initiated. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is usually initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless with the underlying barely moving. Let's look at a theoretical example using ABC Corp. (ABC). Let's say the stock is currently trading at $187.50. The stock looked like it could drop lower. The trader could consider buying a bear put or selling a bear call spread.

If the option trader expected a move lower into the close of Friday, he or she could have considered buying a 185/187.5 debit spread for December expiration (let's say 4 days from now). If the 187.5 put cost the trader 2.25 and 1.15 was received for selling the 185 put, the bear put (debit) spread would cost the trader $1.10 (also the maximum loss if the stock is at $187.50 or higher at expiration) and have a maximum profit of $1.40 (2.50 (strike difference) – 1.10 (cost)) if the stock was trading at or below $185 at expiration. Thus the risk/reward ratio would be 1/1.27.

If the option trader was unsure if the $187.50 stock was going to move lower but felt the stock would at least stay below a resistance area around $190 by December (4 days from now) expiration, the trader could sell a 190/192.5 credit spread with December expiration. If a credit of 1.00 was received for selling the 190 call and it cost the trader 0.50 to buy the 192.5, a net credit would be received of $0.50 for selling the bear call (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $190 or lower at expiration and the maximum loss is $2 (2.50 (strike difference) – 0.50 (premium received)) if the stock is trading at or above $192.50 at expiration. Thus the risk reward ratio would be 4/1.

Probability

The risk/reward ratio on the credit spread (4/1) does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move lower at some point to profit. If the stock stays around $187.50 or moves higher, the puts will expire worthless and a loss is incurred from the initial debit ($1.10).

With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move below $187.50, trade sideways and even rise to just below breakeven at $190.50 (190 (sold call) + 0.50 (initial credit)) at expiration and the credit spread would profit. Of course if it closes at $190 or lower, the maximum profit of $0.50 is achieved because the spread expires worthless. A loss is only realized if the stock closes above the breakeven level of $190.50. I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way of profiting especially if the underlying is basically around the long option when the spread is initialized.

Conclusion

There are several more factors to consider when choosing between a debit spread and a credit spread like time until expiration, implied volatility and bid/ask spreads just to mention a few. We will talk about these other factors in future blogs. The risk/reward of the spread and the probability of the trade profiting are just a few to consider mentioned above. A trader always wants to put the odds on his or her side to increase the chances of extracting money from the market. The credit spread can put the odds substantially on the trader's side but it comes at a cost of a higher risk/reward ratio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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