Monday, October 12, 2009

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

If you missed the first two installments of The Trade Off: Risk-Reward vs. Probability of Profit, check them out here:


Once a trader understands the relationship between risk-reward and probability of profit they typically ask the following question: How do I change the risk-reward or probability of profit of a vertical spread? The answer lies in changing the strike prices one is using in the trade.

Let's use a bull put spread on the S&P 500 to illustrate. Suppose the Index is currently trading at 925. Using current option prices I have constructed a table illustrating three potential bull put spreads we could place on the Index. Pay close attention to the difference in the risk-reward and probability of profit (click image to enlarge).


The risk-reward and probability of profit characteristics of these three spreads holds true to our prior assertion that as we increase the probability of profit, generally we lower the maximum reward. For example, although the 1000-990 put spread has the best risk-reward characteristics, risking $275 to make $725; it also has the lowest probability of profit. Remember, the Index is currently trading at 925. To realize our maximum reward on this spread, the Index would have to rise 75 points to 1000. On the other hand the 880-790 put spread has the worst risk-reward, risking $855 to make $145; but has the highest probability of profit (84%). To realize the maximum reward on this spread we simply need the Index to stay above 800; not a hard proposition considering the Index is already trading at 925.

This is the primary reason why there is not a cookie cutter approach to entering vertical spreads. whereas one trader may enter a bull put spread by using puts one or two strikes OTM, another trader may use puts that are four or five strikes OTM. The bottom line is to make sure that you're comfortable with the risk-reward AND probability of profit characteristics of the trade.