Monday, April 20, 2009

The Trade-Off...

....Risk Reward vs. Probability of Profit

Anon posed a thoughtful question in response to last Thursday's post on credit spreads that I wanted to respond to today.

OK.. I will admit that this strategy [vertical spreads] is new to me, and I am intrigued as I also came across folks who favor Iron condor strategy. Given my background, help me get over the following psychological hump, if you will. I am a value player meaning buy low sell high (mainly stocks) but when I look at accepting $1 credit for $5 potential risk, I agonize. I understand one of the way to manage this risk is through position size and maybe rolling up/down. At the same time looking at the stock charts for any resistance/support areas.But still, how should I address my concern of risking $4 for a potential $1 reward?Any advice?

Anon,
How do I incorporate risk-reward in my option trading?
First off, it depends on what type of option strategy your utilizing. One of the mistakes novices make is applying a rule they've heard about a specific strategy (such as buying call options) to a different strategy such as iron condors. Iron Condors, as well as any other options strategy are completely different animals, thus requiring seperate rules for entry, exit, and management. So make sure as you continue your education you specify which rules/techniques correlate with which strategies.

When stock trading, many traders look for price patterns that exhibit a 2:1 or 3:1 reward to risk ratio (or some other variation) to ensure that the potential reward is worth the risk. Calculating risk-reward is an integral part to evaluating stock trades because we're anticipating the stock to move either higher or lower. Assuming there's a 50-50 chance you're going to be right, you can expect to be wrong about half the time. In that type of scenario we would want to ensure that we're making more money on our winning trades, than the losses we incur on our losing trades. Hence the need for a 2 or 3:1 reward to risk ratio.

The one type of option trade where I can see the need for a 2 or 3:1 reward/risk ratio would be a directional call or put trade. You're odds for those are about as good as a normal stock trade, so I would want to see a decent R/R ratio. For the record, I generally use support/resistance in analyzing my targets and stops for directional call-put trades (although I rarely play them).

So what about Risk-Reward for Credit Spreads or Iron Condors?

To really understand option spreads you've got to consider probabilty of profit. Prob. of profit can be established by using Delta. The following table uses a $10 vertical spread to illustrate the tradeoff between probability of profit and risk-reward.

$10 Vertical Spread
Risk: $1 Reward: $9 Probability of Profit: 10%
Risk: $2 Reward: $8 Probability of Profit: 20%
Risk: $3 Reward: $7 Probability of Profit: 30%
. . . . . . . . .
Risk $7 Reward $3 Probability of Profit: 70%
Risk $8 Reward $2 Probability of Profit: 80%
Risk $9 Reward $1 Probability of Profit: 90%


While there may be situations where a $10 vertical spread deviates from the above table, the majority of the time the relationship between risk-reward and probability of profit will hold true. In short, the higher the probability of profit, the lower the maximum reward. Conversely, the lower the probability of profit, the higher the maximum reward. Typically when trading stocks, we can simply use risk-reward to determine whether or not a trade is worthwhile. Unfortunately many option strategies, require us also to assess the probability of profit. In the options world, it’s insufficient to simply know that one is risking $5 to make $10. We also need to establish the likelihood of realizing the $10. Let’s look at two extreme examples to illustrate the point.

For our first example, consider the following question. Would you risk $9 to make $1? Most traders would immediately answer with an emphatic no! After all, you would be taking on quite a bit of risk, for a paltry reward. However, let’s shed a little more light on this potential trade by further assuming that your probability of realizing the $1 gain is 95%. Would this influence your decision? It most definitely should! Given this extremely high probability of profit, this trade would be a winner in the long run, thus despite the small potential reward it would behoove us to take the trade.

For our second example, consider this question: Would you risk $1 to make $9? Most traders would answer to the affirmative! Moreover, it seems as if it’s a no brainer. However, let’s add the additional variable of probability of profit. Let’s assume the probability of realizing the $9 is 8%. How would this influence your answer? Hopefully it would cause you to avoid the trade and find a better one. Although the risk-reward makes the trade appear like a no-brainer, the small probability of profit better make you think twice! Given the measly probability of profit, this trade would be a loser in the long run.

Does this mean I only take trades with a positive Expected Value?

Not necessarily. I've highlighted many $10 spreads where I received a mere $1 credit and that probably had a negative expected value. The reason I'm comfortable taking the trade is because although the THEORETICAL risk is $9 (which makes it have a negative Expected Value), my MANAGED risk is probably around $3 or less (which would make it have a positive Expected Value). Moreover, by using delta hedging techniques I can further mitigate my risk if the stock makes an adverse move.

Tyler-

5 comments:

Anonymous said...

Thanks for the clarification, I understand it much better now.

If you don't mind, could you shed some light on the timing of your entry.

I understand that you like to enter 4-6 weeks in advance, and exit when the spread can be closed at $0.20 or less or a week prior to the Options expiry, but would you look at the charts for a better entry point? ( I understand you mentioned it for your directional strategies but how about spread strategies?)

I guess could you give some rules for entering the trade besides 4-6weeks rule?
1. looks liike you want small bid/ask spread, liquid options/underlying security.
2. looks like no major market moving event during the holding period (such as earnings/govt. actions, etc.)

but any other considerations?

Anonymous said...

one more thing I wanted to throw out there and didnt see where you stand is:

Do you consider market (or individual security) position while entering the trade? Like wait for the pullback before entering the bull spread and vece versa let the security/market go up to enter the Bear spread? I understand this strategy maybe for a short term entry point like maybe 2-4days, but do you take this into account?

Thanks

Rob said...

Thanks for the thought provoking discussion - I want to use this to refine my strategy somewhat.

I have done very well trading vertical spreads. For one thing, time decay is always on my side. I never sell a spread more than 4 weeks out (i.e. I always trade within the current option cycle). My decision to trade is not dependent on the price of the underlying stock, but on the trend of both the market and the stock. So, if both are trending upwards, I will sell a put credit spread. I use a probability calculator like the free one at Optionvue, and make sure that I pick a trade that has a 90% chance of succeeding. I usually trade on expensive stocks (like GOOG and CME) because they give me better return relative to the broker commission. Finally, I make sure that there are no upcoming earnings reports or major events that would have a dramatic effect on the stock.

Once I have sold my spread, I will watch it. If the trends holds, the spread will approach zero value, and I will buy it back and sell another one closer in. Last year I did this for RTP five times in the 4 week cycle, and made a 70% ROM. I have several times done this two days before expiration.

I do also watch for the trend going the wrong way. If the price gets within a very short distance of the spread, I will often buy back the spread and sell another one further out, and usually end up with a net zero trade (not counting commissions).

This is a pretty active way of trading vertical spreads, but it certainly works for me, and it does not take a lot of time.

Tyler Craig said...

Anon,

There's no doubt, chart reading & timing is key when playing direcctional trades. If I'm playing directional credit spreads then I am ALWAYS looking for a price pattern to time my entry. So when I'm 4 - 6 weeks to expiry, I'll only enter the trade if I have a valid price pattern.

If I'm using bull puts, then I'll look to enter on retracements of an uptrending stock (See my Tuesday April 14 post for example). Conversely, bear calls are entered at resistance.

I usually play SPY or RUT with these credits, so I'm always analyzing the price action on these indices to determine whether or not they're presenting a tradable opportunity.

The one exception to using price patterns to time the entry is when I'm playing a market neutral strategy such as iron condors. I merely enter a certain number of weeks prior to expiry.
Tyler-

Tyler Craig said...

Rob,

Thanks for your thoughts. I'm glad to see the spreads are working well for you.

Tyler-