Selecting Strategies Based on Risk vs. Reward
May 8, 2017
Sometimes in life, it’s prudent to take a step back in order to gain fresh perspective. Traveling is certainly an effective method of getting perspective on your life at home.
Perspective is valuable for investors and traders, too. Trading sometimes produces stress, which can in turn consume our thoughts with a specific position or outcome. When this occurs, it's easy to "miss the forest for the trees."
When you break it down to its simplest form, the intent of trading is to use capital to produce additional capital. The amount your strategy produces over time, as compared to your original amount, is the return on capital.
Obviously, investors and traders accept a certain level of risk in order to produce returns. In turn, the level of risk taken has an associated level of reward. This is the risk-reward paradigm so frequently referenced in the investment industry.
Due to the amount of "noise" produced in financial media relating to strategies and products, it's important to take a step back and consciously acknowledge the level of risk and associated reward that best suits your goals and profile.
Not doing so could mean that the one-off trades you are making are formulating your broader strategy - which is essentially the tail wagging the dog. Instead, determine what it is you want from your capital, and then establish a trading or investment approach that allows you to get there.
A recent installment of Options Jive may assist you in this process. The episode is titled "Strategy Selection Based on Risk & Reward," and can help traders better understand the spectrum of strategies available to develop a customized approach while taking the desired level of risk.
It's possible you may decide to separate your capital into two or more buckets. The first that strives to generate a more modest return, while taking less risk. The other bucket, which may have substantially less capital, could be dedicated to slightly higher risk-reward approaches.
As discussed on Options Jive, one of the most important choices traders make when deploying capital, in terms of risk-reward, involves the potential for gains and losses.
A defined risk position means that a trader will know their potential maximum gain, their potential maximum loss, and the space between. On the other hand, undefined risk strategies theoretically expose a trader to "unlimited loss," under certain conditions and scenarios.
In the options world, a good example of a defined risk position is a vertical spread.
A vertical spread involves buying and selling options with the same expiration, but different strike prices. When executed 1-to-1 (meaning the same number of long and short contracts), vertical spreads offer defined risk whether you are the buyer or the seller.
Alternatively, straddles are undefined risk positions, and offer the potential for unlimited loss or unlimited gain, depending on the side taken and outcome. A straddle involves a call and put with the same strike price and expiration.
A long straddle is executed by purchasing both the call and put; offering defined loss (the premium paid for the straddle), and potentially unlimited gains (the farther the underlying stock moves from the strike price, the better). A short straddle is executed by selling both the call and the put; offering potentially unlimited loss (the farther the underlying moves from the strike price, the worse), and limited gain (the amount of premium received from selling the straddle).
According to the above information, a trader with a super low-risk tolerance might choose to avoid ever selling a straddle, consequently cutting off the potential for unlimited losses. That same trader, however, may choose to sell vertical spreads, which offer limited risk characteristics.
This episode of Options Jive should help traders further define (or refine) their trading approach, and optimize their risk-reward exposure in the market according to their own unique profile.
We recommend watching the entire episode of Options Jive focusing on strategy selection based on risk-reward when your schedule allows. The single most important takeaway from this program is that investors and traders always need to understand and accept the risks of any position before entering it.
We hope you'll follow up with any feedback in the "comments" section below, or by contacting us directly at firstname.lastname@example.org.
As always, thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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