Profit and Probability – Part 2

With the results of the election nigh and the reaction likely to produce a binary event it’s appropriate the second part of this series we drill down into analyzing risk/reward. The upshot is you not need be right all the time.

In the first part of this series we discussed how returns need to calculate returns on a risk adjusted basis in both percentage and dollar terms. This is applied not within the context of each position, but the overall portfolio. Now let’s take a look at how setting up the proper risk/reward profile for each individual position will boost overall profitability.

A big secret many rich traders know that new traders do not is the winning percentage for even the best traders is only about 50%-60%. Having big winning trades and small losing trades is their edge.

Big losses will kill your account quickly and small wins will do little to pay for those losses. Our trades have to be asymmetric, where our downside is carefully planned and managed, but our upside is open ended. This is a crucial element for trading success and has to be understood and planned for. Consider the following sets of risk/rewards with win rates.

  • With a 1:1 risk/reward ratio and 50% win rate a trader breaks even.
  • With a 2:1 risk/reward ratio and about a 35% win rate a trader breaks even.
  • With a 3:1 risk/reward ratio and about a 25% win rate a trader breaks even.

The risk/reward ratio is used by more experienced traders to compare the expected profits of a trade to the amount of money risked to capture profit. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (the reward) by the amount the trader could lose if price moves in the unprofitable direction and the trader is stopped out for a loss.

Don’t Play the Lottery  

One of the biggest mistakes novice option traders is buying way out-of-the-money calls. These options through their typically low dollar cost seemingly set up a great risk/reward profile. You can only lose what you pay for the option and profits are theoretically limitless.

I refer to these as lottery tickets because you are much more likely to rip them with a 100% loss than you are to hit the jackpot. And remember these options come with an expiration date, meaning you not only need an outsized price move, but it has to occur within the right time frame.

In addition to these OTM options having a low probability of success they also may not be as “cheap” as they seem. In options it’s not just the dollar amount determining whether it relatively cheap or expensive, it is the implied volatility. Often the implied volatility on these OTM is very high causing inflated premiums. This is especially true ahead of pending news such as earnings or takeover chatter when the lottery aspects of these come fully into play.

Three Step Approach

In setting up a trade I take three basic steps:

  • Use the chart to find an attractive entry level and define your trade parameters. This means buying near support and selling at resistance levels. This not only provides an attractive initial price, but helps you set a realistic price or profit target. It also limits risk, if support is broken the position gets closed for a small loss. Ideally the price target should be at least twice the price magnitude as the stop loss level.
  • Choose a strategy that will deliver at least a 2:1 risk/reward if the price target is achieved. If the target is small and the stop is tight one can simply buy an at-the-money call. If the parameters are wider than using a spread might make more sense.
  • Allow sufficient time for your thesis to play out. If this is a turnaround story you’ll want options that have an expiration at least 8-12 months away. If you’re just looking for a quick technical bounce or an earnings announcement using a shorter term of options, anywhere from two to three weeks will provide better returns.

A great example is a trade I set up in Priceline (PCLN). The stock sold off in the wake of competitor’s Expedia (EXPE) weak earnings. I identified the $1,000-$1100 level as significant support and therefore a good entry point.

A close below the old lows at $995 would mean I’m wrong and trigger the stop loss.

pcln-tos-110816

The initial price target would be a move back to the 50 dma near the 1180 level. So I had a target price of approximately a $65 price move versus a stop loss of $15, or a 4:1 ratio.

Finally, the strategy I chose was a basic vertical spread. When the shares of Priceline dipped to 1,010 I was able to buy the April $1040 calls and sell the April $1080 calls for a $14 net debit for the spread.

The higher strike, $1080, aligned with my price target and would make the spread fully in-the-money. Of course, due to time premiums it won’t reach the maximum value of $40 until expiration. So I have a profit target to close the position if the value of the spread doubles to $28 for the spread.

To limit the losses I am using a combination of a close below $995, or if the value of the spread slips to $10 level. These two numbers should align.

Therefore I have a position that has a risk/reward profile of over 3:1, $14 potential profit versus $4 loss. Ultimately the position delivered an impressive 100% return on a very reasonable 7% gain in Priceline shares in a two-month period.

This is just one example of how risk/reward measured across time frames can be applied to deliver solid and consistent profits without needing to right all the time.

— Steve Smith

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About the Author: Steve Smith