SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Risk Reward Or Probability Of Success?


How many times did you hear the following claims:

  • "Our system has 90% success ratio".
  • "Our trades have 1 to 4 risk reward".
  • “Always keep your reward to risk ratio greater than 1”
  • “Only take trades with a minimum of a 2:1 reward to risk ratio”
  • “If you aim for more than you risk, then you will make money.”

Lets examine those statements and see how you should put them in context and consider other parameters as well. We will use vertical spread strategy as an example.

 

Lets take a look at the following trade:

 

  • Sell to open RUT August 1175 call
  • Buy to open RUT August 1185 call

 

This is the risk profile of the trade:

 

242c61bf5c2cb13bc166d07a3e4b07c9.png

 

As we can see, we are risking $822 to make $177. This is pretty bad risk reward. However, the picture looks a lot better when we look at the probability of success: it is 78%. We need the underlying to stay below 1175 by August expiration, and there is 78% chance that it will happen.

 

In this trade, bad risk/reward = high probability of success.

 

Lets take a look at another trade:

 

  • Sell to open RUT August 1100 call
  • Buy to open RUT August 1110 call

 

This is the risk profile of the trade:

 

805ce5f279c5ed97f47c3bd2dc82c603.png

 

As we can see, we are risking only $185 to make $815. That's terrific risk/reward (more than 1:4). The only problem is that RUT will have to go below 1110, and there is only 20.7% probability that this will happen. (In fact, to realize the full profit, RUT has to go below 1100 and stay there by expiration).

 

In this trade, excellent risk/reward = low probability of success.

 

The following table illustrates the relation between probability of success and risk-reward:

 

503bc5dca55716d5f4ea06ba2ea53329.png

 

Of course, this is not an exact science, but it helps us to see the approximate relation and trade-off between the risk-reward and the probability of success.

 

So next time someone will ask you: "Would you risk $9 to make $1?" - consider the context. Yes, it is a terrible risk/reward, but considering high probability of success, this is not such a bad trade. It will likely be a winner most of the time - the big question is what you do in those cases it goes against you?

 

At the same time, the answer to the question "Would you risk $1 to make $9?" is also not so obvious. It is an excellent risk/reward, but the probability to actually realize this reward is very low.

 

In trading, there is always a trade-off. You will have to choose between a good risk-reward and a high probability of success. You cannot have both.

 

Watch the video:

 


If you want to learn more about options strategies:

 

Start Your Free Trial

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • The Power of Selling Options on Futures

    It’s no secret that selling far out of the money options, as opposed to buying them, is a trading strategy with a high probability of success. Low-delta options have a proclivity to expire worthless. The dramatic downward moves required to make low-delta options profitable don’t happen all of the time.

    By Kim,

    • 0 comments
    • 71 views
  • How to Control Losses and Protect Profits

    One of the requirements when developing a trading method is that traders have to fully describe how to start and settle trades. However, when they are forced to describe how to adjust and manage the size of their positions, few traders have a concrete answer.

    By Kim,

    • 0 comments
    • 248 views
  • How to Avoid Emotional Mistakes in Trading

    There are some psychological dangers in the market that you should know about. It is important that you know how to deal with your emotions and what steps you must take to achieve your investment goals. Therefore, you must equip yourself with the right tools to be able to implement your operations in a profitable way in the long run.

    By Kim,

    • 0 comments
    • 350 views
  • Volatility Skew

    'Volatility skew' is one of those topics that many traders ignore.  It's not something that was understood in the early days (1973 +), when options began trading on an exchange. According to Wikipedia: "equity options traded in American markets did not show a volatility smile before the crash of 1987, but began showing one afterward."

    By MarkWolfinger,

    • 0 comments
    • 422 views
  • Can Options Assignment Cause Margin Call?

    I've had three emails in the past month on people being assigned on positions and receiving margin calls, and generally not knowing what happened. I advise everyone to completely research and become familiar with the exercise/assignment aspect of option trading. If you don't you can find your entire account blown out over a weekend.

    By cwelsh,

    • 6 comments
    • 5,541 views
  • Calculating ROI on Credit Spreads

    The trigger to this article was a discussion I had with someone on Reddit. There is a common misconception about calculating gains on trades that require margin, like credit spreads and short options (naked puts/calls, strangles or straddles). I believe it is important to explain how to do it properly.

    By Kim,

    • 0 comments
    • 841 views
  • Learning to Win by Learning to Lose

    It does not matter how good your trading system is - you will not win 100% of the time! A fact! The way you deal with this fact will go a long way toward determining how big a winner you become. In fact, after so many years spent in the financial arena, I have absolutely no doubts in my  mind that one of the most essential keys to winning is learning how to lose.

    By Kim,

    • 0 comments
    • 579 views
  • Should You Leg Into Iron Condor?

    The wings of an iron condor options trading strategy consist of two vertical credit spreads; i.e., a bull put spread and a bear call spread. The process of "Legging In" offers the promise of higher yields and enhanced probabilities of options trade success, but the question is whether it is worth the risk.

    By Kim,

    • 0 comments
    • 2,541 views
  • Should You Add to a Losing Trade?

    I'm sure most traders are familiar with this situation. You find a good setup, watch it for a while, then enter a trade, and it goes down right after you entered. Should you double down and add to your losing trade, or should you cut the loss and exit? That depends who you ask.

    By Kim,

    • 0 comments
    • 1,706 views
  • Top 5 Options Trading Myths

    There are a lot of myths and misconceptions about options trading. Many traders refrain from trading options because they consider it too risky. The only dangerous part of options trading is the risk-insensitive trader who buys and sells options with little or no understanding of just what can go wrong.

    By Kim,

    • 0 comments
    • 1,119 views



We want to hear from you!


Guest AkramMajed

Posted

Trading always comes hand in hand with risk and is directly proportional to success. If don't take risk you will not succeed.

Share this comment


Link to comment
Share on other sites

Of course. But it is also important to understand the trade-off between the risk-reward and the probability of success. It is important to understand that when implementing a 90% winning ratio strategy, you sacrifice something - it doesn't come for free. 

Share this comment


Link to comment
Share on other sites

This sounds like one of those "there isn't a right or wrong answer"... I think by place 90% probabilty trades you will be close to "picking up nickles infront of a steamroller"... on the other hand, if you do the 10% probabiliyt trades, they will be lottery tickets and you will rarely win... I don't think neither of those trades can be profitable unless you tweak that system. In the 90% chance trade, it will be that 10% that will wipe you out... 

Share this comment


Link to comment
Share on other sites

Absolutely. It all comes to trade management.

 

There is still a small edge on all those trades (10%, 90% or 50%) due to the fact that in the long term, Implied Volatility tends to be slightly higher than Historical Volatility. But the main edge comes from the trade management.

Share this comment


Link to comment
Share on other sites

With the picking up nickels in front of a steamroller analogy doesn't that really only apply with the spread moves completely against you. Can't you avoid the steamroller by putting a stop loss in place? Are there brokers that have a function where you can have the strategy close out if the underlying security hits a dollar amount? You may get your arm clipped but not run over....

 

I placed an $AAPL bull put spread where I bough the Aug 15 93 put and sold the Aug 15 94 put. I collected 150$ premium and rode it out to collect 90% of the premium before closing out the trade. (The only reason I don't hold into expiration is I am trying to avoid after hours trading debacles)

 

If I had parameters in place to avoid it ever even getting to the 94 mark, wouldn't it make sense to place this trade over and over and over if the probability of success is there?

Share this comment


Link to comment
Share on other sites

Most brokers have this functionality. You just set a contingent order to close or adjust based on certain parameters. We do it all the time in our Steady Condors portfolio. 

Share this comment


Link to comment
Share on other sites


Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   You have pasted content with formatting.   Remove formatting

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

Loading...