Balancing Risk with Reward
For our Auto-Traders,
we control risk by closing out any spread if the underlying
index trades through our breakeven point. Breakeven at expiration is the
strike price of the option we sold plus or minus the credit received,
depending on whether it is a put or a call. If the trade is closed
before expiration, the loss is usually limited to 15%-25%. But for
those trading on their own, here is a simple method to manage risk.
We use our Options Volatility Analysis
to pick credit spread trades with at least an 80% probability of
success. Most of the trades we do have 90% odds of being successful. But
even at 90%, there is still the possibility of a loss. Ninety percent
means that we will win 9 out of 10 trades. Even though we attempt to
limit our risk to 10%, it could still be substantial. So how can we
assure that our strategy will be profitable over the long haul?
If we are trading a 5 point wide credit spread, our risk is the
difference between the strike prices and the credit receive. Our reward
potential is the credit received. So we need to know just how big the
credit needs to be to justify the position. A quick way to determine
this is:
Minimum Credit > Difference in strike prices x probability of loss
For example, if the spread is 5 points and the probability of loss
is 10%, then the credit needed to break even over ten trades is $0.50.
To make a profit, we need something more, say $0.60. That's the
minimum credit we need to meet our risk/reward criteria.
But lets say that the most attractive trade we can find, the one
with a +90% probability of being a winner, only has an available credit
of $0.30. What do we do, pass on the trade? Not necessarily. We can
trade half of our available trading account and still maintain our risk
control:
Percent of Acct Traded = available credit/minimum risk credit
So there you have it. A simple, easy-to-calculate method to
evaluate risk and assure profitability.
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Disclaimer: Options trading has large potential risks. You must be
aware of the risks and be willing to accept them in order to invest in
the options markets. Don't trade with money you can't afford to lose.
This is neither a solicitation nor an offer to Buy/Sell options. No
representation is being made that any account will or is likely to
achieve profits or losses similar to those discussed. The past
performance of any trading system or methodology is not necessarily
indicative of future results.