SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

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

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:

 


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

Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Ready to Invest? Here's How to Get Started with Online Trading

    I am struggling with making the decision to get started.  How much money do I need to be efficient and effective following your instructions?  What software and where to find it?  I could really benefit from extra income but I am also in a position where I can't really afford to lose much so there is some doubt/fear.  But, your information and attitude felt right to me so I reached out.

    By Karl Domm,

    • 0 comments
    • 112 views

  • The Importance  of Proactive Hedging in Options Trading

    Investing in the stock market can be a daunting task for even the most experienced investors. With the constant fluctuations and volatility of the market, it can be difficult to predict the future direction of the market. This is where options trading comes into play.

    By Karl Domm,

    • 0 comments
    • 187 views

  • The Silent Bank Run

    Long before Silicon Valley Bank failed, the banking sector was experiencing a silent bank run. Unlike the Great Depression, where lines of people clamoring for their money were blocks long, this silent bank run, as its name portends, has been out of sight until recently. There are a couple of reasons for this. 

    By Michael Lebowitz,

    • 0 comments
    • 154 views

  • High Probability Strategy: A Holy Grail of Options Trading?

    A lot of options traders consider a 90% probability strategy a Holy Grail of trading. After all, if you can win 90% of the time, you should be able to grow your account very quickly, right? Well, not only this is not necessarily true, but in fact, a Winning Ratio alone tells you nothing about your chances to be profitable.

    By Kim,

    • 0 comments
    • 140 views

  • The 10 Best Options Trading Books

    Options trading can be challenging. I look at it as a journey, a long term investment, which is no different that graduating from University. And like University, you need to do a lot of reading, along with a lot of practicing. Fortunately, there are a lot of books out there that can be of tremendous help in this journey.

    By Kim,

    • 0 comments
    • 254 views

  • OptionNET Explorer (ONE) Software

    OptionNET Explorer (ONE) is a complete options trading and analysis software platform that enables the user to backtest complex options trading strategies, analyze their results and monitor them in real-time, all from within a single, user friendly environment. 

    By Kim,

    • 0 comments
    • 252 views

  • What Happened to SFO Magazine (SFOMag)? Stocks, Options and Futures Magazine

    Remember SFO Magazine? Traders like Jack Schwager and Brett Steenbarger used to write for the publication before its swift shutdown in 2012. What happened. SFO (Stocks, Futures, and Options) magazine was a monthly financial magazine focused on trading and investing in stocks, futures, and options markets.

    By Pat Crawley,

    • 0 comments
    • 867 views

  • How to Use the Finest Covered Call Strategy

    Investing in the stock market can be a great way to grow your wealth over time. However, it can also be a volatile and unpredictable place, with sudden swings in stock prices causing anxiety for even the most experienced investors. This is where the covered call strategy comes in - a popular options trading strategy that can help manage portfolio volatility.

    By Kim,

    • 0 comments
    • 782 views

  • Put/Call Parity

    Put/call parity is a crucial concept in options trading that establishes the basics of option pricing. The formula, introduced in 1969, came years before the seminal Black-Scholes pricing model. As such, it was one of the first formulations of quantitative option pricing and served as the foundation for future pioneers like Black, Merton, and Scholes.

    By Pat Crawley,

    • 0 comments
    • 412 views

  • What Are Cash-Settled Options?

    Options are finite, wasting assets. They have a shelf-life, and they cease to exist after their expiration. So when that expiration date comes, there needs to be a mechanism in place to ensure that both sides of an option contract hold up their side of the bargain.

    By Pat Crawley,

    • 0 comments
    • 944 views
OptionsEnthusiast™ reacted to this
  Report Article
Go to articles Trading Blog

We want to hear from you!


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.

Share this comment

Link to comment
Share on other sites
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. 

Share this comment

Link to comment
Share on other sites
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... 

Share this comment

Link to comment
Share on other sites
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.

Share this comment

Link to comment
Share on other sites
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?

Share this comment

Link to comment
Share on other sites
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. 

Share this comment

Link to comment
Share on other sites
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

Share this comment

Link to comment
Share on other sites
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.

Share this comment

Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido