Is the Reward Worth the Risk?

Testimonials

Posted on Thursday, August 17, 2017 at 3:02 PM

When you read the title of this blog, you probably think that is the first thing you should consider before entering a trade. Smart traders should consider this when entering a trade and in my opinion and it should be documented in your trading plan. But for this particular discussion, I would like you to consider is the reward worth the risk after the trade has been implemented and time has passed.

In my Group Coaching class, I always like to tell my traders that you should consider multiple exits for profit and loss. I cannot tell you how much this has improved my option trading. You have to be a risk manager first and then a trader second to be successful on a consistent basis over the long haul. But why do I have and why should you consider multiple exits? The answer to me is simple and it all boils down to removing risk. I see too many traders that hold positions because they expect to earn the maximum profit or close to it. Now don’t get me wrong, there are some positions that exceed our expectations and the maximum profit is earned sooner than was expected. Those profitable trades are not as common as those that take their time becoming profitable or of course end up losing. Let’s go through an example below that may better illustrate my point.

In class this past Tuesday, we discussed buying an Apple Inc. (AAPL) August 157.5/162.5 bull call spread. At the time AAPL was trading in the $160.75 area. The spread at the time was going to cost about 3.00. This is the maximum risk on this position and it would be realized if the stock closed at $157.50 or lower at expiration which was at the end of the week. The maximum profit is the difference between the strikes (162.50 – 157.50) minus the cost of the spread which in this case was 2.00 (5 – 3). That would be earned if AAPL closed at $162.50 or higher at expiration. The spread had a greater risk than reward but it also had a lower break even than a spread that could have been purchased for less. As I always like to say there are many tradeoffs when it comes to option trading.

Later that same day, AAPL moved higher and the spread’s value moved up to 3.70 meaning a 0.70 ($70) profit could have been realized in less than a day. For some option traders, that might not have been a big enough profit to consider selling some of their position (me not being one of them). But now look at the current risk/reward scenario. There is an additional profit of 1.30 (2 – 0.70) that can be realized but the overall risk has not changed. It is still 3.00. Stop losses cannot guarantee anything but it might be a good idea to consider moving a mental or hard stop up to remove some risk.

What if the spread became even more profitable would your thoughts change then? If AAPL continued to move higher throughout the week, the spread’s value might increase to 4.50 which would be a nice profit of 1.50 (4.50 – 3). Now the potential profit left at this point would only be 0.50 but once again the risk remains at 3.00 (max risk). For at least a majority of your contracts, one should ask is it worth the additional gain when so much is still at risk?

I picked a vertical debit spread for this example but what if an out-of-the-money (OTM) vertical credit spread was chosen and the initial reward to risk would have been even worse based on the criteria. A profitable credit spread would make the new reward/risk even more skewed.

Option traders will sometimes only think about the initial reward/risk scenario when entering a trade. If you consider yourself a risk manager, which I believe you should, then the reward/risk should also be considered as the trade is active especially after a profit can be realized.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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