Consider the Risk/Reward Ratio

Everything about option trading has risk/reward consequences. As I like to tell my students, if you give up this, you get this in return. If you get this in return, you are giving up something. This is a brief reminder of that fact and to think about it all the time as an option trader.

Synthetically, vertical debit and credit spreads are the same. Many traders sell out-of-the-money (OTM) credit spreads. Why does this trade have a seemingly unfair risk/reward ratio? In other words, why are you risking a lot more than you are willing to make? The answer is because the odds are on your side to profit so the risk is higher.

Let’s say a stock is trading at $53 and you sell a 50-strike put and buy a 45-strike put creating a bull put spread. You have three out of four ways to profit at expiration. The stock can move higher, trade sideways or move lower. As long as the stock closes at $50 or higher at expiration, maximum profit is realized.

If you bought an at-the-money (ATM) or in-the-money (ITM) vertical debit spread, the risk/reward ratio would be closer to even. If a stock was at $81 and you bought an 80-strike call and sold an 85-strike call to create a bull call spread, you really have only one way to profit at expiration. The stock would need to move higher than the breakeven of the trade. There is no three out of four ways to profit. With that comes generally a risk that is equal to the reward.

Option traders should consider what changes if different trades are modeled. There is always something that will change and you need to realize what it is. This will help you profusely as a trader.

John Kmiecik, Market Taker Mentoring

Trader Education