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Risk Reward Vs. Probability Of Profit

By Kim

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:

 


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Guest AkramMajed

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.

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Kim

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. 

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biotrader

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... 

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Kim

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.

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CostaKapo

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?

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Kim

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. 

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Guest uktrader

Guest uktrader

Posted

what you have forgotten to explain is that even with a 78 percent win rate you could still get 4 to 5 losing trades in a row so risking 800 to make 200 in your exanple would be a financial disaster should you run into these horrendous losing clusters

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Kim
1 hour ago, Guest uktrader said:

what you have forgotten to explain is that even with a 78 percent win rate you could still get 4 to 5 losing trades in a row so risking 800 to make 200 in your exanple would be a financial disaster should you run into these horrendous losing clusters

Of course. But this is true with any trade. This is where position sizing and risk management come in place. If you make 10-15% on you winning trades, you cannot afford to lose more than 20-25% on your losing trades.

There are few dimensions to every trade. Risk/reward, probability of success, risk management etc. The point is that you cannot take just one dimension (like 80% winning ratio) and say that this is what makes this trade better than others.

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