Kim 8,035 Report post Posted August 17, 2012 By Mark Wolfinger, Options For Rookies One of the truths about trading and investing is that we must take risks to seek a reward. Sure, the professional arbitrageurs try to take zero risk and earn a small reward with each trade. However, those plays are not available to the retail trader. Where to draw the line It is never easy to know exactly where to draw the line. For example, reward/risk ratios are one widely used method for determining whether a trade is good enough. When trading an iron condor, many traders feel that a ratio is acceptable when the premium is $2 to $3 for a 10-point iron condor (ratio 1/5 or ~1/3). Others prefer to trade options that are father OTM and are willing to collect $1 for a 10-point iron condor. Here the ratio is 1/9. There is no correct ratio because market conditions, the traders style, etc are always a factor. Next there is the decision of how much profit to seek from the trade. This is far more important than the original reward/risk ratio. Why? Because these use REAL numbers. The original R/R may be 1:5, but if we plan to exit with a $125 profit and not allow losses (when a gap opening does not result in a larger loss) to exceed $250, then we have a much more accurate ratio of 1/2. Reality forces us to make a decision on certain factors. We can change our minds (later) about maximum profit or loss, but we cannot change the original premium or delta when the trade has already been made. When we decide to enter into a trade, most of us have some minimum premium that we are willing to accept. That establishes the original R/R. But, as mentioned, it is more important to take potential profit and loss numbers from our trade plan. We also choose spreads to sell. Again, we have a line to draw. We can establish a maximum delta for pour shorts, or we can choose CTM options where the original delta is not as important [Clarification: there is a significant difference for the traditional iron condor trader whether the delta is 10 or 12. But for the CTM trader, 25 and 27 are essentially the same. Unlimited loss trades It is not always easy to determine how much cash is at risk. When we own stock or sell naked puts (not cash-secured), we understand that the stock could go to zero. However, we also know that it never happens – at least not without plenty of chances to get out of the trade. That begs the questions:If you buy $100,000 worth of stock, how much is at risk. If we cannot know that answer, then we cannot calculate our return on risk. My belief is that return on investment should not be our standard when writing naked puts. I don’t truly know how to decide how much is at risk, but one reasonable compromise could be to use the margin requirement for the naked put. If we accept that (and not everyone will), then the covered call writer should also use the naked put margin as the positions are equivalent. The difficulty of that decision makes me believe that return on margin is almost always a better measure of risk and reward. Mark http://www.mdwoption...emium/home-page 1 Share this post Link to post Share on other sites
