Friday, October 9, 2009

The Trade Off: Risk-Reward vs. Probability of Profit Part Two

The following table uses a $10 vertical spread to illustrate the trade off between probability of profit and risk-reward.

While there may be situations (based on time to expiry & other factors) where a $10 vertical spread deviates from the 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 stock, we can simply use risk-reward to determine whether or not a trade is worthwhile. As the options arena is a bit more complex, many option strategies require us also to assess the probability of profit. 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 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 probably be a winner in the long run.

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 in probability of profit. Suppose the probability of realizing the $9 is a mere 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! In the long run this trade will probably be a loser.

Hopefully these examples are helping you to begin to realize the significance of not only looking at risk-reward, but also probability of profit.

Looks like this two part series in turning into three parts. Next time I'll review how to change risk-reward and probability of profit by choosing different strikes.


Anonymous said...

The problem with this table is that the profit expectancy is actually zero for every spread since the probability of losing money (the risk number) is 1 minus the probability of acheiving the reward.

Tyler Craig said...

I don't see how that's a problem if it's in line with reality. The model shows a simplification of what one typically finds when assessing vertical spreads with various risk-reward/prob. of profit characteristics in the real world.

Matter of fact by having an expectancy of zero, it's actually better than the real life examples I gave in part three of the series (the SPX bull put spread examples), As they all have negative expectancy.


Interesting trade